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Retail Investor .org |
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CAPITAL GAINS ARE TAXED AT HALF THE INCOME RATE ... FALSECanadian income tax on capital gains is levied on only half the gains. It is common to hear people interpret this in their conversations and calculations as being "taxed at half the normal rate". This interpretation is correct when talking about the marginal tax rate, which is the tax rate on the next dollar of income. But for many decisions, it is not the marginal rate that should be considered. The average rate is the correct calculation. In those situations the interpretation is wrong. The point being missed is the doubling of the width of the incremental tax brackets when income is capital gains. You may have to read that last sentence a second time. Canada's progressive income tax means that the tax rate applied to the last dollar earned is higher than the tax rate on the first dollar earned. By taxing only half the capital gain, twice the actual gain can be earned in each tax bracket, before the next higher rate is applied. So not only is the income taxed at half the rate, more of it is taxed at lower tax brackets. This magnifies the benefits of capital gains, and makes after-tax comparisons of investment returns more complicated than simply applying half the tax. Using the tax rates of 2006 (the point doesn't change with different rates), the weighted average tax levied on the first $100,000 of income is 11% for capital gains and 29% for interest income. The marginal tax rate for capital gains, at that point, is still the 2nd tax bracket. It is the 3rd tax bracket for interest income.
While we are on this subject, look at the average tax burden (6%)on the first $100,000 of dividend income. In this case, you are pushed into higher tax brackets FASTER because of the gross-up to the taxable income, but the tax credit for taxes already paid by the corporation leaves you in the best possible position.
If you want to play with these numbers and input your own income, use the TaxBurden spreadsheet with current taxrates. The experts get other issues wrong as well. E.g. When giving examples they will almost always presume the top marginal tax bracket. Most people face much lower rates. The expert's point may be justified by the top tax bracket, but be completely false for those in the bottom tax bracket. Another point they often get wrong regards the 'effective tax rate' for capital gains. While dividends and interest are taxed each year, capital gains are only taxed when the security is sold. The time lag between the realization of profit and its taxation allows for reinvestment of the before-tax-profit. The longer the deferral, the lower your effective tax rate. On the same TaxBurden spreadsheet there is a tab at the bottom for a separate sheet calculating the effective tax rates for capital gains after a deferral. |