It’s a good problem to have: built-up capital gains in a portfolio are evidence that you made money! Through steady contributions and consistent returns, investors often watch the gains embedded in their non-registered account grow over time. As satisfying as it may be to see your account grow, capital gains can often balloon to a magnitude that can be scary when it comes time to pay the piper. For higher rate taxpayers, the eventual realization of those capital gains would attract a tax bill of approximately 25%.
The fear arising from writing a large cheque to the CRA can often freeze investors who are trying to delay the inevitable. This “tax phobia” often leads to investors holding securities for longer than they should. A hyper focus on the tax bill can even cause investors to forget that gains are not a bad thing; in fact, they are the clearest sign that you made money! The worst thing that could happen is holding a security long enough for those gains to evaporate…
When deciding whether to make a change to your portfolio that would trigger a capital gain, there are a couple of factors that investors should take into consideration:
- Expected relative performance of the securities (i.e. Are these still good investments?)
- Cost of ownership (i.e. Have I received good value for what I am paying for?)
- Annual Tax Drag (i.e. Does my investment create an annual tax burden?)
Although evaluating this decision may seem overwhelming, investors should take comfort in knowing that each of the above factors can be modeled into a financial projection leading to a concrete outcome. There is a right or wrong answer depending on the circumstances! Ironically though, the factor that is often least discussed when deliberating over a portfolio change is the annual tax drag. Let me illustrate an example for a non-registered investor as to why it should not be overlooked:
| Current - (Typical) | Proposed - (Tax-Efficient) |
| Investment Balance - $1,000,000 | Investment Balance- $1,000,000 |
| Embedded Gain - $200,000 | Cost of Triggering Gain - $50,000 ($200K x 25%) |
| Expected Total Return - 6% | Expected Total Return - 6% |
| Portfolio Allocation - 100% US Equities | Portfolio Allocation - 100% US Equities |
| Taxable Distributions - 3% foreign dividends | Taxable Distributions - None |
In review of the chart above investors will notice a couple of things:
- Annual Tax Drag - The Current portfolio grows inefficiently in a sawtooth pattern due to the annual tax burden (50%) arising from the receipt of foreign dividends.
- Breakeven Period - Even though triggering a capital gain ($50,000) to change from the Current portfolio causes the alternative to begin at a lower balance ($950,000), it only takes a few years for the Proposed portfolio to “break even” or catch up.
- Capital Gains - Both the Current and Proposed portfolios are subject to capital gains in year 20 upon disposition. The gain on the proposed portfolio is larger as it has been growing annually at 6% tax deferred until this time.
- Wealth Creation - The tax deferral (no annual dividends) afforded by the Proposed portfolio added $391,962 of wealth to the bottom line despite starting $50,000 behind initially.
Investors need not feel stymied or frozen by the capital gains in their portfolio. Through financial projections and thoughtful analysis, investors can weigh the merits of making a portfolio shift even in light of embedded gains. The annual tax drag associated with a portfolio should not be overlooked; as shown in the chart above, it is a key driver of the portfolio’s future growth potential.
One of the easiest ways out of some capital gains in your portfolio can be had through making a charitable donation. It is common knowledge that in-kind donations of property, such as publicly traded shares or mutual funds, afford donors both a charitable tax receipt for the full market value of the investment and the opportunity to avoid paying taxes on the embedded gains in the gifted security. Making gifts using this strategy has been a “no-brainer” for advisors and investors alike.
Talk to your advisor.