What is Happening to Capital Gains Tax?

Implications for Canadian Investors

Lee is a diligent Canadian investor who has been carefully building an investment portfolio over the years. Lee’s financial journey includes a Registered Retirement Savings Plan (RRSP), a Tax-Free Savings Account (TFSA), and a substantial non-registered account. Let’s examine Lee’s story and explore how the proposed changes in capital gains tax could impact his financial well-being.

 

Lee’s Investment Landscape

RRSP – Registered Retirement Savings Plan

Lee’s RRSP is like a well-protected nest egg. It currently holds a total value of $360,000, with $160,000 of unrealized capital gains. The RRSP has been his long-term retirement savings vehicle, sheltering his investments from immediate taxation.

 

TFSA – Tax-Free Savings Account

In his TFSA, Lee has accumulated $150,000, with $50,000 in capital gains. The TFSA provides a tax-free haven for his investments, allowing them to grow without any immediate tax implications.

 

Non-Registered Account

Lee’s non-registered account is where he has the most flexibility. With a substantial value of $750,000, this account carries $200,000 in capital gains. Unlike the RRSP and TFSA, the non-registered account doesn’t offer any tax-deferred benefits. However, it allows Lee to invest freely without contribution limits.

 

The Proposed Changes

Lee wakes up one morning to the news of the 2024 federal budget proposal. The inclusion rate for capital gains is set to increase from 50% to 66.67%. His heart skips a beat as he calculates the potential extra costs. What does this mean for him?

 

Threshold Concerns

Lee realizes that the proposed change applies to capital gains realized above $250,000. At first, he panics at the thought that his capital gains are well over the limit when he includes all three accounts. Upon quick reflection, however, he remembers that neither his RRSP nor his TFSA is subject to capital gains tax. Assets in Lee’s RRSP (or RRIF – Registered Retirement Income Fund) are not subject to tax until withdrawn and when that happens, it doesn’t matter how the growth inside the account occurred; it will all be taxed as income. As for his TFSA, the term “tax-free” includes capital gains as well as interest and dividend income, so the proposed new rate is irrelevant. Only the capital gains that have accrued in his non-registered account are vulnerable. He wonders if he should sell some of his securities before the new rules kick in.

 

Market Efficiency: Already Priced In

Lee has read here and there about market efficiency, which has prompted him to invest in index funds in the first place. The Efficient Market Hypothesis (EMH) suggests that stock prices already reflect all available information. If this is true, then any price adjustments due to the inclusion rate increase may have already occurred. Selling now, especially since the capital gains in his non-registered account are below $250,000, doesn’t seem necessary.

 

Business Ramifications

Lee continues to wonder about the broader implications. Could this affect businesses? Perhaps companies will adjust their strategies or dividend policies. They don’t even have the $250,000 threshold available to them before the new inclusion rate kicks in. He wonders if he should consult his financial planner. He also reflects on having over 50% of his investments in Canadian equity Exchange-Traded Funds (ETFs). Should he reduce his exposure to Canada and become more globally diversified?

 

“Invest in the US!”

The next Saturday, Lee gets together with his friends for their usual weekly breakfast. As usual, the conversation drifts toward politics, with the budget and their respective investment portfolios top of mind. One of Lee’s friends, John, is a diehard advocate for investing exclusively in the US. He starts off by pointing out that the US tax system is different than the Canadian system so asserts that his investments won’t be affected by this change. Lee, somewhat skeptically, asks how that could be since John is a Canadian citizen living in Canada and he files taxes with the Canada Revenue Agency, not the US Internal Revenue Service.

 

Sheepishly, John admits that he hadn’t thought of that. Since he invests in US stocks, he’s read a lot about the advantages of long-term capital gains (lower rates), the ability to select tax lots when you only sell a part of your investment, and the ability to use capital losses to offset up to $3,000 of ordinary income. None of these apply to John, though. However, he soon brightens up by pointing out that the US has done better than any other market in the last decade and intones once again that the smart thing to do is to invest in the US.

 

Will there be an economic impact?

Another of Lee’s breakfast friends, Dave, speculates about the larger economic impact. While the government suggests that only a small fraction (0.13%) of the population will be affected, Dave has read some commentaries suggesting that this could hinder Canada’s economy.

 

Investor Behaviour

Dave says, “Look at us. We’re wondering about whether we should change the way we invest. I’m sure we’re not alone.” He’s read that higher taxes on capital gains might discourage investment since the after-tax return will decrease. This could lead to a reduction in capital available for businesses to expand and put money into research and development (R&D), potentially slowing economic growth.

 

This Too Shall Pass?

Finally, the oldest of the breakfast gang, Bob, who fancies himself somewhat of a historian, notes that the capital gains tax inclusion rate has changed over the years. Under the Progressive Conservative government of Prime Minister Brian Mulroney, in the late 1980s, it was raised from 50% to 66.67%. From 1990 to 1999 it was set at 75%. In 2001, it was returned to 50% during the Liberal government of Prime Minister Jean Chrétien. “So,” Bob concludes, “while we’re facing an increase again, it’s not the highest rate we’ve experienced in any of our lifetimes, and who knows, it may change again. I’m not going to invest any differently than I have for the last 20 years.”

 

Contemplating the Next Move

The guys chat some more and then move on to their other favourite topics like which Canadian team is going to win the Stanley Cup this year (Given John’s focus on the US, he says it will be either the Rangers or the Islanders since they are the two teams closest to Wall Street). Afterward, while Lee takes his usual 20-minute walk home from the restaurant, he contemplates his next investment move. Should he sell portions of his non-registered account to lock in gains at the current inclusion rate? Or should he stay the course and trust in the market’s wisdom? He recalls an old saying: “Don’t let the tax tail wag the investment dog.” In other words, while tax considerations are important, they should not drive investment decisions entirely. For now, Lee’s long-term strategy remains intact—a diversified portfolio, thoughtful asset allocation, and a focus on his financial goals.

 

This is the 244th blog post for Russ Writes, first published on 2024-04-22

 

If you would like to discuss this or other posts, connect on Facebook,  Twitter aka X, LinkedIn, or Instagram.

 

Click here to contact me for an appointment.

 

Click here and select FinPlan30: Financial Planning in 30 min under Specific Questions for a 30-minute free no-obligation financial planning conversation.

 

Click here for a 2-week free trial of the Money Architect Financial Planning platform.

 

Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions