Once tax-sheltered accounts (RRSP/TFSA) are filled up, it's common for physicians to build up a non-registered investment portfolio – either personally or through a medical corporation – to continue building wealth for retirement. Investments held in a non-registered account in Canada are subject to capital gains or losses whenever these funds are sold.
Savvy investors should review their non-registered portfolio holdings annually to determine if it makes sense to trigger a capital gain or a loss.
What is a capital gain?
Most investors are familiar with the fact that assets sold inside tax-advantaged accounts such as their RRSP and TFSA aren't subject to taxes. But assets held outside of these sheltered accounts (often called non-registered accounts) are subject to tax treatment, from any investment income earned during the year and from when an asset is sold for a higher price than it was originally purchased.
The latter is called a capital gain — the difference between the price you originally paid and the price for which the asset was sold. An "asset" could mean anything: stocks, bonds, mutual funds, exchange-traded funds or real estate that is not your primary residence, such as a rental property or a cottage.
Tax treatment of capital gains
Let's say earlier this year you bought 1,000 shares of an individual company's stock at $10 per share ($10,000 total) and held the investment inside a non-registered account. The stock price increased by 20%, meaning the market value of your investment is now worth $12,000, so you decide to sell the shares for a tidy $2,000 profit.
Selling the shares triggers a taxable event, and because the market value of the shares is worth $2,000 more than you originally paid for them you have incurred a capital gain of $2,000 for this tax year.
In Canada, 50% of the capital gain is taxable and added to your income for the current tax year. So, in the above example, 50% of the $2,000 capital gain ($1,000) will be added to your income and taxed at your highest marginal tax rate. (The rate of tax that will be applied to a taxpayer’s next dollar of income earned.)
Diving deeper, if you earned $75,000 in gross income this year from your job and also incurred a capital gain of $2,000, you would report the capital gain on your tax return and $1,000 (50% of $2,000) would be added to your income, giving you a total taxable income of $76,000.
Crystallizing capital gains
When a non-registered asset is sold at a profit, that action is referred to as “crystallizing” a capital gain. Knowing that such a sale is subject to tax treatment, why on earth would an investor deliberately trigger or "crystallize" a capital gain?
One compelling reason is when the investor is in a lower marginal tax bracket this year than they expect to be in the future. Crystallizing the capital gain means adding 50% of the gain to your income in the year the transaction occurred.
This situation could occur if the investor had a period of unemployment due to a layoff or parental leave, or retired early to mid-way through the year.
Another reason to crystallize a capital gain is when pairing the gain with a capital loss. For example, an investor may have unrealized gains of $10,000 from a U.S. equity mutual fund while at the same time having unrealized losses of $8,000 from a more speculative technology stock.
Selling these investments would trigger both a capital gain and a capital loss, the result of which would be a $2,000 cumulative capital gain. This may be an easier tax situation for the investor to manage than if they had triggered a $10,000 capital gain with no corresponding loss.
Deferring capital gains
Not triggering a capital gain simply means deferring those taxes to a future year. Upon death, assets held in a non-registered account are deemed sold: any capital gains incurred will be added to the income on your final tax return.
So if the question is between paying tax now or paying tax later, a savvy investor – or their advisor – can decide to crystallize capital gains at the optimal time to save on taxes.
Consider an Ontario investor in her final working year who is earning $200,000 annually. She holds a large non-registered investment portfolio with sizable unrealized capital gains. She wants to make a change to her investment portfolio, but her financial advisor reminds her that triggering capital gains during her working years would result in taxes of between 48.35% and 53.53%, depending on the amount of gains that get added to her income.
Instead, the advisor suggests waiting until retirement, thus deferring the capital gains until her income and marginal tax rate are much lower.
A tax-aware advisor would know that deferring the capital gains into retirement, when income is typically lower, would considerably reduce the tax bill resulting from capital gains.
Knowing when to crystallize a capital gain can save you a significant amount of tax throughout your lifetime. Talk to your MD advisor* about an appropriate plan to deal with your capital gains.
* MD Advisor refers to an MD Management Limited Financial Consultant or Investment Advisor (in Quebec), or an MD Private Investment Counsel Portfolio Manager.
The above information should not be construed as offering specific financial, investment, foreign or domestic taxation, legal, accounting or similar professional advice nor is it intended to replace the advice of independent tax, accounting or legal professionals.