Tax Planning – When Procrastinating Can Actually be a Good Thing – Part Two
Part One of this article focuses on how you can often save money on your taxes by deferring when you trigger income taxes. Although you can maximize your savings if you can arrange to trigger this day of reckoning until a time when you are in a lower tax bracket, you may still be ahead of the game even if you would still end up in the same tax bracket; although you may not save any taxes, you would still be ahead after taking any interest saved on loans or any investment income you receive during extra time you have the use of the money that will eventually be used to pay taxes.
Part Two explains steps you can take to give yourself this type of flexibility. In other words, while Part One explains why have the flexibility to decide the best time to trigger a tax bill is a good thing, Part Two shows you how owning investments that produce capitals can make this happen. I will save some specific strategies for converting more of your non-registered portfolio to capital gains investments for Part Three.
Capital Gains – How They Are Taxed
In our tax system, all types of income are not created equal (unless you own them in registered investments like RRSPs, TFSAs and RRIFs, where they are treated the same). Some types of income are taxed at different rates and, while most types of income must be taxed on a yearly basis, this is not always the case. Capital gains are an exception to that rule. Even better, when it does come time to pay tax on capital gains, only 50% of the actual income is taxed. Effectively, this means that the tax rate on capital gains is half of the rate you would have to pay on interest, salary, rent or business income, which are all fully taxed. Capital gains may be taxed a higher or lower rate than dividends, depending on your tax bracket and province of residence. On the other hand, except for a few situations involving private companies, dividends don’t provide the same deferral opportunities. As a result, I will focus on capital gains for the remainder of this and the next article.
How are capital gains taxed? Unlike interest or income, capital gains are only taxed when the gain is “realized”, which is generally when an asset is sold or the owner dies, with a few exceptions. As a result, if you can control when you sell, then you can control when you are taxed.
Despite my comments in the previous paragraph, married or common law tax payers may not face a major tax bill on their death if they leave behind a spouse. If the assets with capital gains are left to the surviving spouse or the trust for his or her benefit, that person or their trust inherit the assets with unrealized capital gains in the same tax position as the deceased. The gain is only realized when the survivor (or the trust for the survivor sell) or when the survivor dies, if any unrealized gains remain at that point. As a result, the big tax bill on death is usually reserved for the last –to-die, unless assets with unrealized capital gains are left to other heirs (again with a few exceptions, such as farms left to children or grandchildren). In other words, our tax system even allows deferral beyond the grave in some situations!
Our tax system also provides some other tax advantages to investors with capital gains. If you have investments that decline in value when you realize them, you are allowed to offset this “capital loss” against capital gains. Even better, if you are willing to refile your tax return, you can carry those losses back up to 3 years and apply them against gains you were taxed on at that time, which can produce a tax refund.
No capital gain now or in that time frame? You can also carry those losses forward indefinitely to use when you eventually do earn a capital gain. If this has happened by death, you can use the portion you have carried forward against other types of income you have earned that year or the year before.
Unfortunately, it is not always possible or wise to delay realized capital gains until you are in a lower tax bracket. Most obviously, if you are worried about an asset declining in value in the future, it might be better to realize the gain even if this means a higher tax bill. As well, many people who own mutual or segregated funds outside their registered funds may be at the mercy of their fund managers; for most types of mutual funds, a fund manager with no knowledge of your person tax situation decides when to buy and sell investment inside a mutual fund. Once this happened, the gains are generally passed along to the individual share or unit owners who must declare the gains on that year’s tax return.
As a result of this lack of control, many mutual fund owners face yearly capital gains tax slips, which undercuts their ability to defer the tax bill. On the other hand, there may be another capital gains bill when the owners sell or redeem their own shares or units, which represents the unrealized gain or loss on the remaining investments in the fund at that time. In other words, owners may still retain some control over when they realize their capital gains by determining when they sell their own shares and whether this is done all at once or over several years.
As many mutual fund owners can attest to, this double level of capital gains can be extremely confusing and frustrating at times. For example, during down markets, it is not uncommon for share or unit holders to get tax slips for capital gains even though the value of the fund may have plummeted along the way; the fund manager may have sold off some assets that increased in value but held onto others that are worth less than their purchase price. As a result, the poor shareholders get tax slips despite the fact their portfolios are worth a lot less than when the year started. If they sold their shares, they would be able to use the capital losses on their shares against the gains passed onto them from the fund manager (or can carry back the losses as described above). Ironically, in many cases, selling at the bottom of the market might be exactly the worst time to bail out. Once again, the best time to sell an investment for tax reasons may not be the best time to sell for investment purposes.
Our tax system provides a lot of advantages to investors who own assets that produce capital gains but only if these investors have control over when they realize the gains. As a result, investors who choose investments that produce unrealized capital gains outside their registered plans may be able to produce superior investment returns by simply controlling when and how they sell. Of course, as I illustrated earlier, the best time to sell for tax reasons isn’t always the best time for investment purposes; sometimes it makes sense to bite the bullet and trigger tax bills rather than risk waiting until retirement if the investment looks poised for a crash. All the same, this added flexibility provides savvy capital gains investors with the opportunity to make their money go further. The next article will provide specific strategies to put more capital gain-producing assets in your investment portfolio, as well as a few other tricks to defer the tax bill for registered plans, too.