Topic: How To Invest

Capital Gain Investment Choices for Maximum Portfolio Returns

Stocks are a better capital gain investment choice than either real estate or bonds—and you can use them to minimize the tax burden on your portfolio

We think it’s a mistake to build your portfolio in such a way that you have to do the impossible such as predict the future direction of any single investment. You’re better off focusing on investments that can generate current income plus long-term capital gains.

Still, we see stocks are a better choice as a capital gain investment than other investments, including real estate or bonds. They are far more liquid than real estate, and are less vulnerable to a rise in interest rates. (A rise in interest rates would push up mortgage borrowing costs, which could cut into demand for real estate.)

Stocks also provide much higher income than you get in most bonds today, and they’re also less sensitive than bonds are to a rise in interest rates. (Bond prices and interest rates are inversely linked. When interest rates go up, bond prices go down, and vice versa.)

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How to minimize the tax burden of a capital gain investment and other portfolio holdings

Because the Canadian capital gains tax is lower than the tax on interest and on dividend income, capital gains is a very tax-advantaged form of income. However, since most investors have income of all three types, here are two strategies for structuring investment portfolios to minimize the tax burden.

  1. 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 (if you hold any) in an RRSP.
  2. More speculative investments are best held 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.

A properly structured investment portfolio can let you take advantage of the low tax rates on capital gains and dividend income while sheltering your higher-taxed interest income in your RRSP. If you make dividends or capital gains in an RRSP, you gain the tax shelter of the RRSP, but 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.

Stocks as a capital gain investment—and realized capital gains

Realized capital gains occur when you sell an asset for more than you paid for it.

With stocks, you only incur a capital gains tax liability when you sell or “realize” the increase in the value of the stock over and above what you paid for it.

In contrast to realized capital gains, interest and dividend income are taxed in the year in which they are earned.

You have to pay the capital gains tax liability you incur 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 capital gains tax on a portion of your profit. The “capital gains inclusion rate” determines the size of this portion.

In Canada, the capital gains inclusion rate is 50%. That means that capital gains are taxed at a lower rate than interest.

Bonus tip: Don’t sell your stocks too early if you want to reap the full benefits of a capital gain investment

Stock prices tend to move in short spurts, interrupted by lengthy periods when they mainly move sideways. For this reason, sometimes investors who only focus on price, rather than the fundamentals of their investments, may make changes just for the sake of change.

Selling stocks because you are bored with them is not the kind of mistake that brings immediate losses, but it’s 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:

  1. Be quicker to sell low-quality stocks, and slower to sell shares of high-quality stocks.
  2. 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)?
  3. Avoid portfolio tinkering, especially when it comes to selling stocks that you feel have gone up 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, and they keep doing it for years if not decades.

Do you believe the tax on capital gains should be higher than it is currently? Or is it too high?

What steps do you take to limit your tax liability on investments?


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