Investing Series: How does the capital gains tax work in Canada?

This is a part of the Investing Series.

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A common misconception I had when I first started investing, was about capital gains.

(It’s minor but I figured if I was thinking about it being true at one point, other newbies might think the same thing.)

Everyone kept saying: 50% capital gains tax, and I took it to mean that it was 50% of my profits DOWN THE DRAIN in taxes, just because I made money.

On the contrary!

When they say 50% capital gains tax, they mean that you are taxed on 50% of your gains, not 100%, at your marginal tax rate.

Read: Doing your taxes: myths, the reality and why you should always work overtime without fear

So for instance if you had $1000 invested, and you made $500 profit, you would be taxed on only $250 of it, not on the full $500 that you made.

HOW DOES THIS WORK IN A CALCULATION?

If  you’re looking at just your income of $40,000 a year in Canada, your total income to be taxed would be $40,000 (salary) + $250 (capital gains) = $40,250.

Your $250 would be taxed at your marginal tax rate, which at the federal level is 15%, and in Ontario it is 9.15% (provincial levels of course, vary by province).

Therefore your taxes on your $250 of capital gains is:

Federal: $250 x 15% = $37.50

Provincial (Ontario): $250 x 9.15% = $22.87

You would have made $500, and got to keep $439.63 of it, after taxes, paying $60.37 in taxes.

Here’s a chart I created with tax rates for Canada and Ontario:

Anything you make as “gains” but you haven’t realized (as in you haven’t sold them), is not taxable.

So basically, if you buy an index fund at $100, and in 40 years it grows to $100,000 you will not be taxed during the time you hold it.

You’ll be taxed when you sell it.

This differs from a retirement fund like an Registered Retirement Savings Plan (RRSP) or a Tax-Free Savings Account (TFSA) in Canada in 2 ways:

1. RRSPs let you get a tax CREDIT on the amount you saved into the plan
2. TFSAs let you withdraw any money (profits, gains and all) tax-free any time you want

WHEN YOU SHOULD SELL YOUR STOCKS FOR GAINS

The best time to sell your stocks for capital gains, would be in a low-income year, so that your tax rates are low to begin with, and you can take advantage of that.

WHERE YOU SHOULD HOLD YOUR STOCKS FOR GAINS OR LOSSES IN YOUR PORTFOLIO

The best place to hold stocks for capital gains, is outside of your RRSP or TFSA, because if you have capital LOSSES (exactly the opposite of gains), you can use that as a credit against your taxes.

Otherwise, if you hold stocks or anything for capital gains inside an RRSP or a TFSA, you will just end up losing the money without a tax credit to apply to your income to claim any losses.

Frankly, even if you make a lot of money and have to sell it because the stock is going to tank (or so you think), the capital gains tax we have is pretty sweet at 50% and @ marginal tax rates.

Any long-term set-it-and-forget-it stuff (index funds) should be held in RRSPs and TFSAs as much as possible.

Everything else, outside. Even dividends are favourably taxed up to almost $50,000 in $0 taxation, when held outside of an RRSP or a TFSA.

• Read: How to pay about $200 in tax for $50,000 of income

Plus you can choose when you pay taxes on your gains. When your invested money outside of registered retirement funds are sitting there, gaining a pretty penny, you don’t pay anything in taxes until you sell it, and you choose when to do that!

Either in the year that you have a low-income, or purposefully choose to take less from your company (like I do), and be favourably taxed.