CAPITAL GAINS/LOSSES

Capital gains are a wonderful way to make money because they are taxed at 50% less than interest and employment income but the best part is that they are only taxed when you sell the investment, so potentially you can defer them almost forever (when you die, you can pass to your spouse tax free, but if there is no spouse, the tax is then payable). Combining absolute tax savings with tax deferral is a beautiful concept and it makes sense too. You should be rewarded for taking a risk – capital gains are sometimes hard to get. The only bad part of capital gains is when they aren't gains but are losses. You can only offset these against capital gains. Capital losses can be applied back 3 years to offset previously declared capital gains or can be carried forward forever to be used against future capital gains.

To show the power of tax deferred growth, let's look at an example:

Bob has a stock his grandfather left him (his cost base would be equal to the value on the day his grandfather died) and it was worth $30,000 on the day he inherited it. It pays him no dividends but grows steadily in value year after year at 5% per year. Bob's wife Mary has a GIC that her mother left her on the same day that Bob’s grandfather left him his inheritance (an amazing coincidence) that is also equal to $30,000 and it also grows on average 5% a year. Mary pays the tax on the GIC, but does not take out the interest and she reinvest this at 5% every year too. Both are in a 40% tax bracket. So now let's see how they’ve done 20 years later.

Bob's $30,000 has grown to $79,598.93 and Mary’s has grown to $54,183.34. To be fair, Mary has paid the tax each year and Bob has not, so let's assume that Bob now sells the stock. If he didn’t have the capital gains 50% exclusion, Bob would pay $19,839.57 in tax, leaving him $59,759.36 which is $5,576.02 more than Mary has, even though they started with the same money at the same time and had the same rate of return, all because of the power of compounding (see Power of Compounding for another example of the power of compound interest). And if we then take into account the 50% inclusion rate, that means Bob's actual tax would only be 50% of $19,839.57, leaving him with $69,679.14 versus Mary’s $54,183.34.