The end of the year is approaching fast and this is a good time to start thinking about how to reduce capital gain taxes for the year 2022.
In this article, financial advisor Lin Sok, share with us some tips on how we can reduce the amount of taxes we pay on our capital gains.
What Are Capital Gains Taxes?
When you own an investment or other asset – such as real estate, land, a business or stocks, for example – and later sell that asset for a profit, you have realized capital gains.
As investors, we are lucky to live in Canada. Canada is one of those countries that taxes money earned from investments at a lower tax rate than money earned from labor.
A long term financial objective for most people is to transition, as much as possible, from labor capital to financial capital.
You don’t want to work for your money, you want your money to work for you.
In Canada investment capital is taxed at 50% your tax rate.
For example, let’s say that your tax rate is 30%.
If you earn $100 working in a job you will be taxed $30.
But if you earn $100 from an investment as capital gain, you will be taxed $15 (50% of your tax rate).
In spite of paying lower taxes from capital gains than for labor income, as investor, we would like to pay even less taxes, According to Lin Sok, this is how we can do that.
Avoid short term investments
Think about this for a second. If you make an investment today and sell it for a profit 10 years later, you avoided paying capital gain taxes for 10 years.
On the other hand, if you make the same investment and sell it a few months later, then you have to pay capital gains tax for that current year.
Ideally, you would like to make investments with a 10 years (or longer) time horizon. The fewer transactions you make, the less taxes you pay.
Avoid by all means shot term thinking, short term investments, or investments fads. Focus on time tested investment ideas.
Take Advantage of Tax-Deferred Accounts
The government of Canada allows us to defer our capital gains taxes for many year (even decades) or not to pay taxes at all on our gains through registered accounts.
RRSP (Registered Retirement Savings Plan)
This is an account in which you are allowed to deposit certain amount of money, every year, to provide for your retirement.
Dividends, interests, and capital gains earned in this account are tax deferred until you take the money out of the account.
For example, let’s say you make an investment at age 20 in your RRSP account. That investment, you can sell it and reinvest it as many times as you want to, and you will only pay taxes on the gains when you make a withdrawal. Let’s say you start withdrawing money at age 60. This means you delayed paying taxes on your investment for 40 years. This a beautiful gift from the government.
TFSA (Tax Free Savings Account)
This is another gift from the government. When you put money in this account, you don’t pay any taxes on your interests, dividends, or capital gains, even when you withdraw the money. The only limitation is that you can only put a limited amount of money into this account. For the current year, 2022, the contribution limit is $6,000. Maybe the limit will increase to $6,500 for the year 2023.
It’s hard to believe that many Canadians don’t take advantage of these tax deferral opportunities. Many times the culprit is lack of knowledge, that’s why having the assistance of a financial advisor can become so valuable.
Offset Your Gains With Losses
You win some and you lose some, and you only pay taxes on the net wins.
If you have capital gains in one investment of $1,000 and capital loss of $300 in another investment, you net gain for the year is $700. You only pay capital gain taxes on this net amount. That’s is why it’s good to take into consideration the timing of capital gains. Maybe delaying your gains for one more year would be a good strategy.
Tax-loss harvesting
Another offset strategy is tax-loss harvesting. With this method, you can carry over losses from one tax year into the next, to help offset future gains. Tax loss harvesting only applies if your losses in a given year exceed your total gains.
Let’s say that I lost $1,000 in 2021, and in 2022 I have capital gains of $5,000. I can match my tax loss of $1,000 in 2021 against my gain of $5,000 in 2022 and only pay taxes on the net amount of $4,000.
Bottom Line
Reducing the capital gains taxes you pay on your investments can keep more of your money in your own pocket. Offsets, tax-advantaged retirement accounts and long-term investments things you must take into consideration when developing a strong tax strategy.