Capital gains tax: Selling non-registered investments

Q: My fiancé, 38, is a really good saver and started non-registered mutual funds prior to the TFSA being around. He has $115,000 in non-registered and $15,000 in a TFSA. The T3 income gets larger ever year, which is a good problem to have. However, my fear is eventually his RSP contributions will not be enough to negate paying taxes on the T3 income. He is maxed out on RSPs and has a defined benefit pension, so the deduction limit is not much.

I have asked his advisor if there is a smart way to start transfer of non-registered to TFSA, but she said the capital gains wouldn’t make it worth it. I also asked about corporate class, but we have a small $8,000 investment loan that she said would cause problems, as well as the capital gain issue came up again.

With the TFSA limit now at $10,000 per year, I wish we could shelter more of this money in the TFSA.

Is she correct? Is there another way?

—Sara

A: As you’ve noted, Sara, your fiancé has a good problem, compared to the alternative. He has lots of savings generating lots of investment income. Because the investments have gone up in value, there are underlying capital gains if he sells—profits on the investments that are taxable in the year of sale.

You likely know that an “in-kind” transfer of investments into a TFSA is a deemed sale for capital gains tax purposes. So whether you sell investments and transfer cash or transfer the investments to your fiancé’s TFSA—the same capital gains tax outcome results.

With regards to the concerns about part of the account coming from an $8,000 investment loan, I assume that represents only a small part of the $115,000 current value. So transferring a portion of the account to a TFSA shouldn’t likely impact the tax deductibility of the investment loan. Ideally, you may want to back-track to see if you can determine which investment or investments came from the investment loan and open a separate account for this leveraged portion to make tracking easier.

Corporate class mutual funds are an option to reduce tax going forward on new non-registered investments. They turn interest and dividend income today into capital gains income in the future. So unfortunately, they won’t solve your current capital gains dilemma, Sara.

The capital gains tax payable on your fiancé’s investments could be as high as 25% of the profit or capital gain, depending on your fiancé’s other income for the year and his province of residence. Generally, 50% of a capital gain is taxable in the year it is realized and is taxable at your marginal tax rate.

I’m not sure I agree with his investment adviser’s logic. Even if the investments have gone up by 50% in value, say he sells $10,000 worth this year to make a $10,000 TFSA contribution. His capital gain would be $3,333, half of which is taxable. Let’s assume he’s taxable at the highest possible marginal tax rate of 50% and has to pay $833 of tax.

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Then the $10,000 starts growing, tax-free. Let’s say he would have otherwise earned 5% a year in taxable income (a combination of interest, dividend and capital gains). That’s $500 a year of income. If he were in the highest tax bracket, he could pay up to $185 in tax on that income if one-third of that 5% return came from each of interest, Canadian dividends and realized capital gains.

In the example, it wouldn’t take long for the payment of tax in year No. 1 to be worth it. If he saved $185 in annual tax, by the fifth year, he’d be ahead after paying $833 up front. Besides that, the capital gain and $833 in tax is going to be payable eventually, one way or the other.

Depending upon your fiancé’s tax situation, it may take longer than my estimated five years to realize the benefits. But why not run the numbers? That way, you’re making decisions based on fact rather than speculation, Sara.

At 38 years old, I’d say your fiancé has a lot of years left to realize the benefits of tax-free growth in a TFSA. A bit of tax today could save him a lot of tax tomorrow. And since he’ll spend most of his life living in the long run, I’d focus on the long run–and avoid being short-sighted with regards to tax planning.

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Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto, Ont. He does not sell any financial products whatsoever.

About Jason Heath, CFP

Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever.

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