Topic: How To Invest

Ins and outs of calculating capital gains tax for Canadian investors

Calculating capital gains tax is important for investors so they know how much they owe—and how much they are saving

Capital gains taxes are the taxes you pay when you sell or “realize” an increase in the value of a stock over and above what you paid for it.

Did you know that Canadian capital gains taxes are actually taxed at a much lower rate than interest? Let’s take a look at the process for calculating capital gains tax.

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How to go about calculating capital gains tax

To calculate your total capital gain on a share you sold during the previous tax year, subtract the adjusted cost base of the shares you sold from the total proceeds of the sale. The adjusted cost base of the shares is equal to the cost of the shares plus any costs associated with owning them, such as brokerage commissions.

An example of calculating capital gains tax

Here is a quick refresher on calculating capital gains tax:

For example, let’s say you buy a stock for $1,000 and then sell that stock for $2,000. You then have a $1,000 capital gain (not including brokerage commissions). You would then 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 (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 roughly $295.20 on $1,000 in dividend income.

If you’ve bought shares of the same company more than once, the adjusted cost base you need to calculate your capital gains tax is equal to the average cost of each share. You can determine the average cost by dividing the total cost of all the shares you’ve purchased by the total number of shares you hold.

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 $247.65 in capital gains tax. That would leave you with $1,752.35 to reinvest (not including brokerage commissions).

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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.

Bonus tip: Dividend payments don’t affect your capital gains tax—unless they’re reinvested

Dividend payments in cash do not change the shares’ adjusted cost base. You pay tax on the dividends as received each year at the rate on dividends, not capital gains.

However, if the dividend payments are reinvested in additional shares of stock, then the total cost and total number of shares change after each new dividend reinvestment, and you must recalculate your new adjusted cost base. Note that you must still pay taxes on reinvested dividends each year as received.

Do you now understand the process for calculating capital gains tax? Share your experience with capital gains tax with us in the comments.


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