Before 1972 there was no tax on capital gains in Canada. In that year, as part of a major overhaul of the tax scheme, capital gains taxes were imposed. The inclusion rate for capital gains (the percentage subject to tax) has varied over the years from the present level of 50% to as high as 100%, with stops (both in the year 2000) at 75% and 66% along the way. Now we are going back to 66% inclusion, which means that the effective tax rate for those in the top backet will go from around 27% to around 36% on realized gains. To make matters more complicated, for individuals the first $250,000 of gains in any year will be at the old rate (but not for companies), and the new rates don’t come into effect for another eight weeks. So the question on the mind of most investors is simple. Should I take some gains now and get the lower rate, or simply do nothing, grind my teeth, and take gains when I would otherwise have done so.

It turns out that, as with most things involving taxes, it is complicated. Much depends on how old you are, whether you want to hold the stocks you might sell for a long time, how high the dividend is on the stock, and how well or poorly the stock market will do in the future. In order to assist in decision making, here is a numerical example.

Imagine that you bought 1,000 shares of Royal Bank in your company account at $50/share, and they are now at $135. Congratulations! If you sell today you have a capital gain of $85,000, and using the pre-budget tax rate you would pay (top bracket) $22,500 in taxes. Since you still want to own the stock, you reinvest the after-tax proceeds. You have ($135,000 -$22,500) $112,500 and you can buy back only 830 shares. Let’s assume that the capital gains inclusion rate stays at 66% and that you sell the shares in 10 years at $270/share – good for you, they doubled! Did you make a good decision by paying taxes early?

The person who didn’t sell still has 1,000 shares, now worth $270,000, but with a capital gain of $220,000. At full inclusion that means a tax hit of $81,000 and net proceeds of $189,000.

You have only 830 shares, now worth $224,100, but your cost base is much higher, $112,050, so you only have a capital gain of $112,050 and a tax hit of $40,000. You have net proceeds of $184,100.  Hey, look at that! Selling early cost you $5,000. Having only 830 shares instead of 1,000 really cost you.

But wait, what about dividends? Royal Bank currently pays $5.52 per year, with a dividend growth rate of 7% per year. Over ten years that would amount to total dividends of about $76 per share. If you still own 1,000 shares, you would get $76,000 but if you took the early capital  gains hit you only have 830 shares and your dividends would be only $63,000 or $13,000 less. Altogether, taking the capital gains hit, even at the lower rate, ended up costing you about $18,000. On the current value of your Royal Bank shares, that’s about 13%, or around 1.25% per year, compounded over the ten year hold period.

Here are three important things to note:

  • If you plan to sell shares you own within a year or two, taking the capital gains hit at the lower inclusion rate will be a winning idea.
  • If you plan to hold for ten years as in this example, the strategy is only a winner if the stock you own does not go up as much as the market, or the dividend stays the same.
  • If you own a stock with a high dividend, say 4% as in this example, the longer you own the stock, the more you give up by paying taxes early.

You can see the trend line in the below graph. If the shares are sold within about 3 years, the benefit can be significant. But beyond that point, the benefit becomes negligible, and later turns into a material downside; potentially costing 5% or more of the portfolio’s value in foregone profits.

Our conclusion is that except for very short term investors, paying capital gains taxes early will not save much money and could easily be a losing strategy. For many stocks, particularly high yield names like banks, utilities and telephone companies, the income foregone as a result of paying taxes early may well be greater than the tax savings.

Nobody likes paying taxes and the idea of tax rates increasing quite rightly should make investors consider their strategy. As good carpenters say, measure twice, cut once. In this case we think the analysis is clear, and that doing nothing is the better course of action.