Sometimes it’s better to just pay the Canadian capital gains tax, which can actually save you money and make your investments more profitable.
Investors are always concerned with minimizing their tax liabilities. But sometimes you are better off simply paying your taxes.
For example, here is a story about a client of our Successful Investor Wealth Management Inc. portfolio-management service who was unhappy to see that she had earned capital gains of around $80,000, and would need to come up with $20,000 to pay her Canadian capital gains tax bill. Her first reaction was, “How did this happen? What can I do to stop it from happening again?”
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This was her first experience with a concept that is ignored in some commission-earning circles: Sometimes it’s better to just pay the taxes.
Too much focus on capital gains tax can hurt profits
Back when she was dealing with a broker and sold anything at a profit, her broker would always suggest that she sell anything on which she had a loss. That way, she could “nail down a tax loss” and reduce or eliminate any capital gains tax she had to pay that year.
As a side benefit, she rarely suffered a big loss on any stock, since she sold most of her losers before they fell too far. However, she often noted that she also sold all too many of her best stocks at just the wrong moment, when they were going through a short-term downturn just prior to a big rise. She rarely had a big loss, but big gains were even rarer.
When a series of gains with her broker put her in a position to pay Canadian capital gains tax, she offset it by catching up with RRSP contributions, or buying tax shelters recommended by the broker. The RRSP contributions were highly effective at sheltering her income from tax. The tax shelters were also highly effective at sheltering her income from tax—but they were less effective at making any money for her. In fact, none of her tax shelters left her with anything better than a modest gain. She lost money on most of them, even after allowing for the tax benefits.
But back to the story: Most of her capital gain was from a large holding in a coal energy company, on which we more than doubled her money for her. A larger energy company acquired the coal energy firm. We had no control over the timing of that sale. We could have sold some of her losers to offset a modest part of her gain, but we felt the timing was exceptionally poor in light of the drop in share prices on the market.
Tax shelters: A great way to make money for your broker
When our client asked why we didn’t put any tax shelter in her account to offset the gain, we explained that we generally stay out of tax shelters at Successful Investor Wealth Management Inc. These include such things as the flow-through limited partnerships that are sold by some brokers.
In fact, we stay out of them even more consistently than we stay out of new issues. The reasons why are similar. Neither tax shelters nor new issues are priced according to the interplay of well-informed buyers and sellers, as they are with an investment that is already trading on a stock exchange.
Instead, the sponsors of these investments decide what they are worth, and then pay brokers two to three times the normal, full-service commission rates to sell them to the public at that price. As a result, new issues and tax shelters generate far more than a random share of weak performing, if not disastrous, investment results.
In the end, of course, it’s not as if she has missed out permanently on a tax advantage. To offset capital gains, you can carry capital losses back three years, or forward indefinitely. The only drawback is that carrying the loss forward to reduce taxes in a future year amounts to an interest-free loan to the government. But with today’s low interest rates, that’s the least costly approach to dealing with capital-gains taxes.
In the end, you choose when to pay tax on capital gains
One of the main advantages of the Canadian capital gains tax 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. For example, if you buy stock for $1,000 and then sell that stock for $2,000, you will pay just $247.65 in capital gains tax if you are in the highest tax bracket. 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.
Has it made sense for you to just pay your Canadian capital gains tax? Have you invested in any tax shelters? Share your experience with us in the comments.
Note: This article was originally published in September 2009 and has been updated.