Topic: How To Invest

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

tax on capital gains

In Canada, tax on capital gains is at a lower rate than tax on  interest. You can take advantage of that for the 2018 tax year — and substantially cut your 2018 tax bill — by structuring your investments so that more of your income is in the form of capital gains.

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

About 18 years ago, the Canadian government cut the capital gains inclusion rate from 75% to 66.6% and, within a few months, to 50%. This cuts tax on capital gains, 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 tax on capital gains at a rate of 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 (49.53%), you will pay $247.65 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 49.53% tax bracket, you’d pay $495.30 in taxes on $1,000 in interest income, and you would pay $338.20 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 tax on capital gains. 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 $247.65 in capital gains tax. That would leave you with $1,752.35 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.

This article was originally published in 2016 and is regularly updated.

Tax on capital gains is lower than tax on interest income, but it only comes due when the asset is sold. What weight do you place on that when deciding to sell a stock holding, for example?

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