Worrying Too Much About Capital Gains Can Be Taxing
Thursday, June 10, 2021
Taxes are inevitable, and long-term investors often face the reality of paying capital gains taxes when they sell stocks in their non-registered investment accounts. When this occurs, investors are left with less money to reinvest and compound over time. To offset this impact, investors want the return from whatever new stock they buy to be higher than the stock they sell. Interestingly, the theoretical break-even return required from a new stock to justify a switch may not be as high as some think. This can be illustrated through an example.
Let’s assume an investor living in British Columbia owns Stock A with an adjusted cost base of $10 per share. Stock A currently trades at $100 per share and the expected compound annual return over the next five years is 5%. At the same time, Stock B trades at $75.93 and offers an expected compound annual return of 7% over the next five years.
The investor has two options:
1. Sell Stock A and Buy Stock B
- Sell Stock A and receive net proceeds of $75.93/share after paying capital gains tax at the highest marginal tax rate in BC.
- Reinvest the lower net proceeds in Stock B and earn a higher return (7%).
- Sell Stock B in five years.
2. Hold Stock A
- Avoid paying capital gains tax at this time.
- Earn a lower return of 5% on a larger amount ($100/share).
- Sell Stock A in five years.
After five years, Option 1 yields net after-tax proceeds of $98.31 per share compared to $96.16 for Option 2. In other words, the investor is better off switching from Stock A to Stock B, despite the immediate tax bill.
If Stock B offered a return of 6.4% instead of 7%, the net proceeds for Option 1 and Option 2 would be the same, and the investor should be indifferent between the two choices. Even with a large capital gain for Stock A, the theoretical return differential required to justify switching from Stock A to Stock B (i.e., +1.4%) is not that significant.
All other things being equal, the theoretical break-even return is lower in lower tax rate jurisdictions. For example, the break-even return for an Alberta-based investor in our example is 6.2% instead of 6.4%. The break-even rate for switching also declines as the holding period increases. In our example, that rate decreases from 6.4% for a five-year holding period to 6.2% for a 10-year holding period. In addition, the break-even rate for switching is lower for stocks with smaller capital gains.
The example above is theoretical, but it demonstrates that the rate of return to justify switching may not be as high as some think. In reality, though, investors tend to seek a wider return spread between Stocks A and B given the uncertainty of future returns compared to the certainty of large taxable capital gains.
What would happen if the tax rate on capital gains were to increase in the future? Many speculate that the Canadian federal government will raise the capital gains inclusion rate (currently at 50%) and thus increase the overall tax investors pay on capital gains. From an investment perspective, this would decrease the break-even rate for switching. In some circumstances, Stock B can generate a lower return than Stock A, and an investor would still be better off switching before the inclusion rate increases. If one believes the capital gains inclusion rate is likely to go up during the holding period, it could be prudent to consider alternatives for stocks with large capital gains before a tax increase is announced.
In summary, the impact of capital gains taxes cannot be completely ignored in the investment process. However, we believe investors should focus on maximizing after-tax returns rather than minimizing capital gains taxes. This may entail switching from a stock with lower return potential and large capital gains into another stock offering a higher return.
For more information on your unique circumstances, please speak to your Odlum Brown Investment Advisor or Portfolio Manager.