How to cut your tax on capital gains — and keep more of your money working for you

In Canada, capital gains are taxed at a lower rate than interest. You can take advantage of that — and substantially cut your tax bill — if you structure your investments so that more of your income is in the form of capital gains.

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You have to pay capital gains tax on profit you make from the sale of an asset. An asset can be a security, such as a stock or a bond, or a fixed asset, such as land, buildings, equipment or other possessions. However, you only pay the tax on a portion of your profit. The “capital gains inclusion rate” determines the size of this portion.

Several years ago, the Canadian government cut the capital gains inclusion rate from 75% to 50%. This cut taxes on capital gains by one-third, and had the effect of lowering the overall rate you pay on capital gains to one-half of what you would pay on income or interest.

By the numbers: tax on capital gains

For example, if you buy stock for $1,000 and then sell that stock for $2,000, you have a $1,000 capital gain (not including brokerage commissions). You would pay capital gains tax on 50% of the capital gain amount. This means that if you earn $1,000 in capital gains, and you are in the highest tax bracket in, say, Ontario (46.41%), you will pay $232.05 in capital gains tax on the $1,000 in gains.

In contrast, interest income is fully taxable, while dividend income is eligible for a dividend tax credit in Canada. In the 46.41% tax bracket, you’d pay $464.10 in taxes on $1,000 in interest income, and you would pay $230.60 on $1,000 in dividend income.

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You choose when to pay tax on capital gains

One of the main advantages capital gains have over other forms of investment income is that you control when you pay capital-gains tax. This amounts to a very simple and highly effective way of deferring tax — and it’s perfectly legal.

You pay capital gains tax on a stock only when you sell, or “realize” the increase in the value of the stock over and above what you paid for it. In contrast, interest and dividend income are taxed in the year in which they are earned.

As an added bonus, if you sell after you retire, you may be in a lower tax bracket than you are when you are earlier in your investing career. In any event, the longer you hold onto a profitable stock and put off paying capital gains tax, the longer all of your money works for you.

This can have a significant impact on your long-term returns. To continue with the example above, if you buy stock for $1,000 and then sell that stock for $2,000, you will pay $232.05 in capital gains tax. That would leave you with $1,767.95 to reinvest (not including brokerage commissions).

However, if you hang onto the stock, you keep the full $2,000 working for you until you choose to sell. That holds out the potential for even further gains, and the possibility of paying less tax on your capital gains if you sell after you retire, when you may be in a lower tax bracket.

As a member of TSI Network, you may have already seen Capital Gains Canada: 7 Secrets for Managing Your Canadian Capital Gains Tax Liabilities. If you haven’t yet read this new free report, click here to download your copy today. I’d also encourage you to share the report with a friend. It’s my “thank you” just for signing up for my free daily updates.