FP Answers: Should I rethink my capital gains strategy to prepare for a tax rate hike?

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Q: I’m an active investor with a six-figure portfolio. Even though the 50 per cent capital gains tax inclusion rate wasn’t changed in the recent federal budget, I’m worried that it’s something that will likely change in the near future. Expectations are that President Biden will hike it in the U.S. soon. Does this affect how I invest going forward? And if so, how? What changes would I likely have to make regarding asset allocation if the cap gains inclusion rate rises? Any portfolio management tips would be appreciated.

— Worried in Winnipeg

A: The topic of changing the capital gains tax inclusion rate comes up year after year. The 2021 federal budget did not change the rate, but don’t let rumours of an increase cause you to lose track of the advantages of capital gains over dividends and interest income.

There are three main advantages to investors:

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If you have a $10,000 capital gain you’ll have to include $5,000 (the inclusion rate of 50 per cent) on your tax return. To do a quick estimate of the tax owing on a capital gain add the taxable portion of the gain to your annual income, find your marginal tax rate and then multiply the rate by the taxable gain, in this case $5,000.

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The table below shows the amount of tax a 50-year-old from Manitoba earning $100,000 would have to pay on $10,000 of gains, whether capital gains, dividends or income.

As the example shows, you’ll pay the least amount of tax on capital gains, while interest income carries the highest tax bite, and dividends are in between.

It is interesting to note that in the above investor’s case, an inclusion rate of 75 per cent makes dividends appear to be more tax efficient than capital gains. But this ignores the two other benefits of capital gains investing: the investor’s ability to trigger the tax at a time of their choosing and tax deferral.

Investors have no control over the timing of interest and dividend payments, and both are taxed annually. Capital gains are different. A capital gain is generally not realized until an equity or property is sold or transferred to a new owner. In most circumstances, investors can choose when to sell or transfer an asset and trigger a capital gain.

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This ability to delay capital gains tax until the investor decides to sell is a huge benefit. Imagine investing in something earning 10 per cent interest (that’s high, but work with me here) and you had to withdraw $4,180 each year to pay the tax. Think how that would compare to a capital gain investment, where you can leave all of your money invested to grow, and you don’t have to pay tax until you decide to sell.

I know there will be a lot of unhappy investors — myself included — if the inclusion rate ever does go to 75 per cent, but the good news is that 25 per cent of our gain would still be tax free, we would still have the ability to trigger the tax when we choose, and we can keep more of our money invested longer.

From an investment perspective, there will likely be no reason to make changes to your investment mix if the inclusion rate ever does increase. You will still want to hold tax-efficient investments in your non-registered or open accounts. For registered accounts such as your RRSP, TFSA or RRIF, a change in the cap gain tax rate doesn’t matter mainly because the tax treatment, for the most part, is the same for interest, dividends and capital gains.

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But even if the capital gain inclusion tax rate expectations are true, and the rate does go up in a future federal budget, there really isn’t much the average investor can do. If you have investments you plan to sell or gift to someone, then this may be the time to do it. But if your only reason for making a change is because the tax may increase, it is probably best to leave things as they are.

Allan Norman, M.Sc., CFP, CIM, RWM, is a fee-only lifestyle financial planner with Atlantis Financial Inc., and a fully licensed investment advisor with Aligned Capital Partners Inc. He can be reached at www.atlantisfinancial.ca or alnorman@atlantisfinancial.ca. This commentary is provided as a general source of information and is intended for Canadian residents only. Allan offers financial planning and insurance services through Atlantis Financial Inc.