With capital gains taxed at a lower rate than interest, we advise you to structure your investments to profit from that favourable tax treatment.
It’s no surprise that during the 2016 tax season, investors inundated us with questions about how to cut their capital gains tax liability. In Canada, capital gains are taxed at a lower rate than interest. You can take advantage of that—and substantially cut your tax bill—if you structure your investments so that more of your income is in the form of capital gains.
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. (Although mutual funds generally pass on their realized capital gains each year.)
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.
Several years ago, the Canadian government cut the capital gains inclusion rate from 75% to 50%. This cut taxes on capital gains by one-third, and had the effect of lowering the overall rate you pay on capital gains to approximately one-half of what you would pay on income or interest.
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Here’s how tax on capital gains compares to other forms of investment income:
Capital gains: If you buy stock for $2,000 and then sell that stock for $4,000, you have a $2,000 capital gain (not including brokerage commissions). You would pay tax on just 50% of the capital gain amount, or $1,000. This means that if you earn $2,000 in capital gains, and you are in the highest tax bracket in, say, Ontario (49.53%), you will pay $495.30 in capital gains tax on the $2,000 in gains.
Interest: Unlike capital gains, interest income is fully taxable. In the 46.41% tax bracket, you’d pay $990.60 in taxes on $2,000 in interest income.
Dividends: The dividend tax credit applies to all dividend income from Canadian corporations. As a result, you would pay tax at a rate of 29.52%, or $590.40 on $2,000 in Canadian dividend income.
You control when you 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 incur a capital gains tax liabiilityon 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 tax on capital gains, 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 $2,000 and then sell that stock for $4,000, you will pay $495.30 in tax on your capital gains. That would leave you with $3,504.70 to reinvest (not including brokerage commissions).
However, if you hang onto the stock, you keep the full $4,000 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.
Retiring soon and need to lower your tax liability?
If you’re like many Canadians that are looking to retire in near future, cutting your capital gains tax liability is just the beginning. Here are three tips to lower your taxes on your retirement income.
1. Have the higher income spouse pay the household bills: The easiest way to even out income between two spouses is to have the higher-income spouse pay the mortgage, grocery bills, medical costs, insurance and other non-deductible costs of family life.
Remember that you have to keep separate bank accounts and accurate records. The higher-income spouse can also pay the lower-income spouse’s tax bill each spring, and any installments or any capital gains tax that are due during the year.
All of these measures will let the lower-income spouse build a larger investment base. They’ll also cut the amount of tax the lower-income spouse pays on retirement income and investment income earned now.
2. Set up a spousal RRSP: Registered retirement savings plans, or RRSPs, are a form of tax-deferred savings plan designed to help investors save for retirement. RRSP contributions are tax deductible, and the investments grow tax-free. (Note that you can contribute up to 18% of your earned income from the previous year to a maximum of $21,000, rising to $22,000 in 2010).
When you later convert your RRSP to a registered retirement income fund (RRIF) and begin withdrawing the funds, they are taxed as ordinary income.
A spousal RRSP is one way to achieve equal retirement income. Suppose you are the higher-income spouse. You can make contributions to a spousal RRSP, and claim the tax deduction. Your contributions to the spousal RRSP will count toward your annual RRSP deduction limits.
Your spouse can still contribute their full deduction to their own separate RRSP. When the money is withdrawn from the spousal RRSP years later, it is taxed in the hands of your spouse. If he or she is in a lower tax bracket any capital gains tax you might incurred is not a significantly lower rate.
A spousal RRSP is also a way to defer taxes if you are no longer able to contribute to a personal RRSP because of your age. As long as your spouse is 71 or younger, you can contribute to his or her spousal RRSP and still claim the tax deduction.
3. Pay interest on your spouse’s investment loans: If the lower-income spouse takes out an investment loan from a third party, such as a bank, the higher-income spouse can pay the interest on that loan.
For example, say you’re the higher-income spouse and you make an interest payment on your spouse’s investment loan. As long as you don’t repay any of the loan principal, you do not have to claim any of the investment return on your income taxes. You should, however, make sure to pay the interest with a personal cheque bearing your name, so it’s directly tied to you.
The lower-income spouse would then deduct the interest payments on the loan on his or her tax return, even though the higher-income spouse paid them. This strategy lets the lower-income spouse build up a larger investment base.
Have you used any of the techniques we’ve mentioned above to lower your capital gains tax liability? Have you tried something different? Share your experience with us in the comments.
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