One person you can be sure won’t be getting any valentines on February 14 is the taxman.
At this time of the year, Canadians are getting their tax slips and coming to grips with just how much they owe the government for 2021.
The tax owed on dividend and interest income tends to be fairly steady from one year to the next. The wild card is capital gains. They can produce an unwelcome surprise at tax time, especially for those living on their portfolio income.
Capital gains represent the increase in value of an asset such as an investment or a piece of real estate over time. A capital gain is realized when the asset is sold or considered to have been sold by the government.
In Canada, 50% of your capital gains are taxable at your marginal tax rate. As a result, for Quebec residents who earn more than $221,708 per year, the combined federal/provincial marginal tax rate for capital gains is 26.65% in 2022.
Depending on the buying and selling that’s gone on in your non-registered investment accounts, the amount of capital gains tax you pay can fluctuate quite a bit from one year to the next.
In 2021, the large stock market gains led us to rebalance portfolios by selling equities and purchasing bonds. While this is a by-product of strong markets, it also means a larger capital gains tax bill than in other years.
By contrast, we realized capital losses in 2020 in many client portfolios as a result of the market decline triggered by the pandemic. While you can’t claim a capital loss in your taxes in the year it occurs, you can carry it back up to three years to recover past taxes paid on capital gains, or you can carry it forward indefinitely to offset capital gains in the future.
The unpredictability of capital gains from year to year also means variability in the income tax instalments people have to pay over the course of the year. This is because the government bases your instalments on the amount of income you earned in the previous year.
Unfortunately, we have no way of knowing ahead of time how much capital gains tax our clients will pay in any given year because we can’t predict how the markets will perform and hence what rebalancing we will have to do.
The good news is we use passively managed exchange traded funds that are more tax efficient than actively managed mutual funds. Active fund managers make many more trades than a passive ETF in an (often futile) effort to beat the market. All that activity tends to generate more capital gains for unitholders of active funds, even if they didn’t sell their units during the year!
The benefits of disciplined rebalancing to mitigate portfolio risk ahead of the next downturn outweigh the nuisance of paying capital gains tax from time to time.
The title of this article is obviously meant to be tongue in cheek. No one is actually going to learn to love the capital gains tax. But the pain of paying it should be softened by the knowledge that it’s the product of growing investments and prudent portfolio management.
There’s been quite a bit of speculation that the federal government might raise the 50% capital gains inclusion rate to bring in more tax revenue. Does it make sense to sell some of your investments now to crystallize your gains at the lower rate? I tackle that issue in an upcoming video. Please watch for it.