Canadian capital gains tax is always on the minds of investors even as they deal with market downturns
There are three main forms of investment income in Canada: interest, dividends and capital gains. The government taxes each differently. Here’s a reminder of how smart investors use their knowledge of taxation rates, especially in the case of Canadian capital gains tax.
With stocks, you only pay capital gains tax when you sell or “realize” the increase in the value of the stock over what you paid. (Note: mutual funds generally pass on their realized capital gains each year.)
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Several years ago, the Canadian government cut the capital gains inclusion rate (the percentage of gains you need to “take into income”) from 75% to 50%.
For example, if an investor purchases stock for $1,000 and then sells that stock for $2,000, they will have a $1,000 capital gain. Investors pay Canadian 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 (53.53%), you will pay $267.65 in Canadian capital gains tax on the $1,000 in gains.
The other forms of investment income are interest and dividends. Interest income is 100% taxable in Canada, while dividend income is eligible for a dividend tax credit in Canada. In the 53.53% tax bracket, you’ll pay $535.30 in taxes on $1,000 in interest income; you will pay $393.40 on $1,000 in dividend income.
Canadian capital gains tax is lower than the tax on interest and on dividend income. So, capital gains is a very tax-advantaged form of income. However, since most investors have income of all three types, here are three strategies for structuring investment portfolios to minimize the tax burden.
It is usually best to hold any common shares outside of an RRSP (as dividend income and capital gains taxes are taxed lower than interest income), and interest-paying investments in an RRSP. (Still, it’s okay to hold shares in an RRSP–especially if you don’t hold any fixed-income investments.)
It’s best to hold more speculative investments outside of an RRSP. If investors hold them in an RRSP and they drop, investors not only lose money, but they can’t use the losses to offset any taxable gains from other investments.
Regarding mutual funds outside an RRSP, the main consideration is that mutual funds make annual capital gains distributions even if investors continue to hold the fund units. Investors then pay Canadian capital gains tax on half of any realized capital gains. So you are best to hold mutual funds in an RRSP and common stocks outside. You won’t realize capital gains on common stocks until you sell.
2. Structure your portfolio
A properly structured investment portfolio lets you take advantage of the low tax rate on capital gains and dividends. At the same time, it shelters your higher-taxed interest income in an RRSP. If you make dividends or capital gains in an RRSP, you gain the tax shelter of the RRSP. However, when you withdraw the funds from your RRSP they are taxed at the same rate as interest income. This means you would lose out on the lower tax rates offered.
3. Determine whether you should be selling your stocks in the first place
Stock prices tend to move in short spurts, interrupted by lengthy periods when they mainly move sideways. For this reason, sometimes investors focused on price ignore the fundamentals quality of their investments. They then may make changes just for the sake of change.
You may not suffer losses immediately if you sell stocks because you are bored with them. But you’re sure to cut deeply into your long-term returns. The reason is that the market’s top performers can bore you to tears for months or years at a time. However, even though they may go sideways for a long time, these stocks may then set off on a big rise. If you sell out of boredom, you would miss that rise.
Use these three tips to see if you should be selling your stocks in the first place.
Be quicker to sell low-quality stocks, and slower to sell shares of high-quality stocks.
Before you sell, ask yourself this: does the stock have a poor fundamental outlook? Or do you want to sell because it just isn’t going up fast enough (see boredom above)?
Avoid portfolio tinkering, especially when it comes to selling stocks you believe have risen too far and too fast. To succeed as an investor, you need a big winner in your portfolio from time to time. One key fact about big winners is that they tend to go up further and faster than most investors expect. They can keep doing that for years if not decades.
If you are considering making use of tax-loss selling to minimize capital gains in Canada, you should also be aware of the “superficial loss rule.” It states that if an investor, their spouse or a company they control, buys back a stock or mutual fund within 30 days of selling it, they are prohibited from claiming the capital loss. Failing to obey the 30-day rule will result in the capital loss being disallowed.
For additional guidance, subscribe to The Successful Investor, our award-winning conservative investment advisory for investors interested in high-quality, mostly Canadian stocks. Those tend to surge ahead in good markets and hold their own in the face of market declines. It focuses on low-risk stocks with strong profit and growth potential, and we’d love to have you as a member.
Have concerns about paying capital gains tax encouraged you to hold onto a stock longer than you otherwise would have?
This article was originally published in 2014 and is regularly updated.
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Your perspective on the taxation of investment income is sort of misleading.
Taxing dividends the same as earned income is actually double taxation (once when the corporation earns it and again in the hands of the share owner). To remedy this there is a dividend tax credit to reimburse the investor for taxes paid by the corporation on his behalf. This is not a special bonus, tax advantage, preferential treatment or a loophole.
The same sort of thinking can be applied to capital gains. The corporation earns money and pays taxes. The net income goes into retained earnings, increasing the value of the company. Taxing this gain is again double taxation. In light of this the government only taxes half of it.
Also there is an inflation component to capital gains. Taxes on inflation doesn’t seem like preferential treatment.
My concern is not so much the double taxation issue, but promoting investment income as somehow tax advantaged.
Then again, maybe I’m not seeing this right. If that is the case I would appreciate it if you could show me where my thinking has gone wrong.
Replying to an older post but I’ll offer my two cents anyway. John, you make valid and interesting points but the reasons for the tax structure are largely irrelevant to the individual investor. What does matter is risk-adjusted, after tax returns. That is the perspective that Pat is trying to impress upon investors. The income tax rules make it more profitable to take a certain amount of risk vs the guaranteed alternatives, especially in the prolonged low interest rate environment that we find ourselves in.
Very good info for the average individual with limited knowledge, happy new year and stay safe.
Very interesting but now to what use would you put a TFSA ? That too offers an advantage or two. Every stock I own which ends in .UN pays a distribution NOT a dividend . Distributions are taxed like earned income or salaries, so I put all .UN stocks in my TFSA.