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Of all types of investment income, you pay the lowest tax on deferred capital gains. Paying tax 20 years from now on a capital gain is much better than paying tax on a dividend or capital gain this year. How do you invest for deferred capital gains?

In recent years, many investors have been focusing on dividend investing, because of a search for yield and preferred tax rates. However, the lower tax rates only apply to Canadian corporations, so investing for dividends gives up global diversification. You end up heavily over-invested in Canada.

There are other disadvantages of dividend investing. Dividend paying companies are usually mature and slow growing. Due to the popularity of dividend investing recently, many dividend paying companies are quite expensive today.

Investing for deferred capital gains offers significant benefits. They are generally taxed much lower than Canadian dividends and do not limit you to Canadian or mature companies.

Capital gains and Canadian dividends are both taxed at lower rates than interest. Dividends are taxed lower for lower income Canadians and capital gains are taxed lower for higher incomes.

However, deferred capital gains are taxed at a lower rate, plus the tax can be deferred for years (or decades) into the future. Paying tax on dividend income every year bleeds away your capital to invest. Paying tax 20 years from now on a capital gain is obviously much better.

If you have investments outside your RRSPs and TFSAs, such as Smith Manoeuvre investments, here are 6 ways to invest for deferred capital gains:

  1. Buy-and-hold: Capital gains are deferred until you sell. This means you need to buy investments that you are comfortable holding for many years. This long term perspective is a good idea in investing anyway. Studies show that buy-and-hold investors tend to outperform frequent traders. One great example is Warren Buffett. His holding period for almost all his holdings is “forever”.
  2. Invest in funds: A little known fact is that people that pick their own stocks pay a lot more tax. Mutual funds, seg funds, pooled funds and ETFs get tax credits every year based on the capital gains allocated to investors that sold the fund at a gain. It is called the “Capital Gains Refund Mechanism” (CGRM).

This is a technical accounting thing, but very significant. In short, if the capital gain on stocks sold inside a mutual fund were taxable and then the growth of the mutual fund was also taxable, there would be double tax on the same gain. To avoid this, every time an investor sells a fund at a gain, the fund gets a tax credit for that gain.

This means that the long term holders of a fund usually get a steady stream of capital gains tax credits. Fund investors can often invest for 20 or 30 years with their fund being up 300% or 500% and all holdings in the fund turned over a few times – and yet the fund investor may get little or nothing in capital gains distributions (T3 or T5 slips) at year-end.

If an investor owned the underlying stocks directly, he would have to pay close to 20% of his capital in taxes over the years. Investors that own their own stocks or are in “separately managed accounts” (SMAs) with a broker are often considering the tax consequences every time they sell a stock.

As an aside, high net worth investors are often marketed the worst products. Brokers market separately managed accounts to high net worth investors claiming tax advantages, because they are not “pooling their tax position”. However, the fact is that investors in SMAs usually also pay far more tax. Pooling your tax position is highly beneficial. It gives your fund a steady stream of CGRM tax credits.

In short, fund investors that own their fund longer term benefit from significant CGRM tax credits their fund receives.

Here is an article on CGRM: https://edrempel.com/capital-gains-refund-mechanism-why-mutual-fund-and-etf-investors-potentially-pay-less-tax/.

  1. Funds that buy-and-hold: Funds that tend to keep their holdings longer tend to have lower capital gains to distribute. From my experience, most All Star Fund Managers have a longer term perspective on their holdings. This means smaller or no T3 or T5 slip at year-end.
  2. Corporate class mutual funds: This type of mutual fund can net the gains from one type of fund against losses in another fund to avoid having to distribute capital gains. This works best when a fund company has many sector and regional funds in their corporate class structure, not just core broad-based funds.

In short, corporate class mutual funds usually have smaller or no T3 or T5 slip at year-end.

For example, if a fund company has a resource fund, a technology fund, a health care fund, an emerging markets fund, a US growth fund and a small cap value fund, most likely some of these funds will have some holdings that are down each year. These losses can be triggered and used to offset taxable capital gains on the funds that went up. For example, the losses on some stocks in a resource fund can be offset against gains in the tech fund that is within the same corporate class.

You can also switch from one fund to another without triggering a capital gain. It is useful not to have to worry about tax consequences every time you reallocate your portfolio.

Unfortunately, the tax benefit of switching funds is being restricted as of January 1, 2017. For example, until the end of 2016, you can switch a Canadian dividend fund to a US growth fund without triggering a capital gain, if both are in the same corporate class. After 2016, you will still be able to switch tax-deferred between 2 funds with identical holdings, such as Class A fund (regular fund) and a Class T fund (pays a distribution). The offsetting of gains between funds is also not affected.

After you retire and need to receive cash flow from your investments, there are 2 methods that focus on deferred capital gains – T-SWP funds and “systematic withdrawal plans” (SWPs). Retirees often think they need income, but what they actually need is cash flow.

Focusing on deferred capital gains can be even more important after you retire, since it can also reduce or eliminate clawbacks on government benefits, such as GIS or OAS. The difference can be massive! For example, a retiree receiving GIS pays 70% on dividends (20% tax plus 50% GIS clawback), but 0% on T-SWP payments, and usually 3-7% SWPs.

  1. T-SWP funds: After you retire and are taking income from your investments, a T-SWP can give you tax-deferred income for 12 to 20 years. For example, a T8 fund will pay out 8%/year which is all considered to be “return of capital” (ROC). It is not taxable until your book value reaches zero. This is in about 12 years for a T8 fund and 20 years in a T5 fund.

You can choose one year every decade or two to trigger the gains, and then restart your tax free cash flow for another 12-20 years.

If you receive a year-end T3 or T5 slip, it is still taxable. However, the monthly payments you receive are all not taxable. They are deferred capital gains.

These funds create a tax problem for the Smith Manoeuvre, though, since they reduce the tax deductibility of an investment credit line, if you borrowed to buy the fund.

  1. Retirement income by SWP: When you retire and are taking income from your investments, you can sell some investments every month to give you the cash flow you need. This is called a “systematic withdrawal plan”. Only the gain portion of the amount you sell is taxable. This allows you to continue to defer tax.

For example, if you invested $100,000 and it tripled to $300,000 when you retire, you could sell $15,000 each year to provide some retirement income. Of the $15,000 you receive, $5,000 is your book value, so only the $10,000 gain is taxable. It is a capital gain, so only $5,000 is added to your taxable income. This is almost definitely lower tax than receiving $15,000 in dividends.

In short, deferred capital gains are the lowest taxed type of investment income. They are taxed at lower rates, plus you can defer the tax for years (or decades) into the future. Paying tax 20 years from now on a capital gain is obviously much better than paying tax on a dividend this year.

It takes some planning to invest for deferred capital gains, both before and after you retire. The tax deferral can be a big benefit in your financial plan.

 

 

Ed

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