Capital gains may be illusory.

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longinvest
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Re: Capital gains may be illusory.

Post by longinvest »

AltaRed wrote: 02 May 2017 18:56
deaddog wrote: 02 May 2017 17:49 I’ll agree that the longer you can defer tax the better, but don’t hold on to losers just to avoid paying tax.
Nor fail to take outsized gains that defy gravity because of the tax tail. A number of memorable examples... Bre-X, Nortel, Tech stocks in general circa 1999,
StuBee wrote: 02 May 2017 19:21 I admit that this comparison may excessivly favor the annual CG scenario. However, so much can happen over a thirty year period that in all likelihood some sales will take place inspite of the best intentions of the "buy and holder". This will further reduce the difference between the two scenarios.
I agree with all of you, here. One should not hold on an investment just to avoid taxes. Occasionally, even a lazy index investor needs to sell ETF units and realize gains to rebalance his portfolio.
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Re: Capital gains may be illusory.

Post by AltaRed »

kcowan wrote: 02 May 2017 19:37 This would seem to favour putting the pure capital gains in your portfolio, and the poorer performers like ETFs and dividend stocks in your wife's portfolio, strictly from an after tax yield perspective.
Probably... based on today's tax regime. We tend to forget the regime has changed mutiple times just in my investing career. We have good discussions here buta lot is outside our control.
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Re: Capital gains may be illusory.

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kcowan wrote: 02 May 2017 19:37
AltaRed wrote: 02 May 2017 13:29Being a bit picky but senior couples cannot necessarily split income sufficiently as to equalize at $75k each. Only eligible pension income counts for income splitting. Spouse gets all her OAS while I do not. But your point is valid. OAS clawback is way overrated and can disproportionately influence decisions.
This would seem to favour putting the pure capital gains in your portfolio, and the poorer performers like ETFs and dividend stocks in your wife's portfolio, strictly from an after tax yield perspective.
Happy to see that someone else agrees that a capital gains strategy outperforms ETFs and dividends. :D
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Re: Capital gains may be illusory.

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deaddog wrote: 02 May 2017 20:20Happy to see that someone else agrees that a capital gains strategy outperforms ETFs and dividends. :D
Oh, I can get very nice capital gains on my ETFs.

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Re: Capital gains may be illusory.

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As do I. The likes of VTI, etc. have most of their TR in capital appreciation.
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Re: Capital gains may be illusory.

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ghariton wrote: 02 May 2017 23:14
deaddog wrote: 02 May 2017 20:20Happy to see that someone else agrees that a capital gains strategy outperforms ETFs and dividends. :D
Oh, I can get very nice capital gains on my ETFs.

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But will you? Or will you according to your plan just go and lie down. :) :)
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Re: Capital gains may be illusory.

Post by Norbert Schlenker »

longinvest wrote: 02 May 2017 13:03 As I wrote earlier: compounding taxes are very bad!
All other things being equal, sure, but they're not. One of the implicit assumptions in your calculations is that every gain gets taxed at the maximum marginal rate. (StuBee referenced this above.) For most people, that wouldn't be true in any year but would certainly apply on a 30 year holding. If you don't take advantage of the progressive rate structure in interim years, you're squandering a non-repeatable opportunity.

Calculations are fun so let's do another one. Instead of 15% annual compound growth, let's say 6%. Let's also say that annual realization of gains gets taxed in the second bracket, which in most provinces these days is around 15%, and that lump sum taxation at the end of 30 years would be at 25%. Then annual realization gets you:

$10,000 x (1 + ((.06) x (1 - 0.15)) ^ 30 = $44,471

while lump sum taxation gets you:

$10,000 x (1 + .06) ^ 30 x (1 - 0.25) = $43,076

With these assumptions, a stitch in time saves nine, and the conclusion is reversed.

Of course, I chose the growth rate of 6% purposely to make this point. But Charlie Munger chose 15% annual appreciation AND a 35% capital gains rate AND 30 years to make his point.
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Re: Capital gains may be illusory.

Post by longinvest »

Norbert,

I am trying to make sense of your post.

Is this a windfall scenario? In other words, all working life long, this person had a modest taxable income (around $30,000, see Quebec Tax Table 2016), then magically, in retirement, this same person who accumulated a sizable non-registered portfolio with no embedded capital gains (they were paid all along) is now getting double that in taxable income (over $60,000, see Quebec Tax Table 2016) in addition to her non-taxable portfolio withdrawals (return of capital).

How likely is that?
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Re: Capital gains may be illusory.

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I remember that yielder also talked about this concept of "cleaning money up" along the way by intermittently realizing capital gains to avoid getting hit all at once in the end.

I have practiced this to a certain extent, but that is more likely reflective of engaging in trading activity rather than a set tax management plan. That said, I do tend to take losses when the market offers them up to carry forward for future use. It has come in extremely handy in the years subsequent to the 2008-09 market crash.
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Re: Capital gains may be illusory.

Post by kcowan »

scomac wrote: 03 May 2017 09:09...That said, I do tend to take losses when the market offers them up to carry forward for future use. It has come in extremely handy in the years subsequent to the 2008-09 market crash.
Yes me too. This is why I found longinvest's analysis (and Norbert's) so instructive. I believe that the assumptions of both are set to be illustrative rather than realistic for the next 30 years. I have used 7% in my financial plan to be "conservative" so I really believe it will be higher. But my guess would be 9%-10%. 8) 8)
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Re: Capital gains may be illusory.

Post by Norbert Schlenker »

longinvest wrote: 03 May 2017 07:27 Norbert,

I am trying to make sense of your post.

Is this a windfall scenario? In other words, all working life long, this person had a modest taxable income (around $30,000, see Quebec Tax Table 2016), then magically, in retirement, this same person who accumulated a sizable non-registered portfolio with no embedded capital gains (they were paid all along) is now getting double that in taxable income (over $60,000, see Quebec Tax Table 2016) in addition to her non-taxable portfolio withdrawals (return of capital).

How likely is that?
I'm not sure what you mean by a windfall scenario. Modify my example just a little by increasing the $10,000 cost amount by ten times, and let's use your Quebec tables. Assume also that there's some baseline of other income around $30,000. (How could this happen? Working class 35 year old inherits $100k from Grandma and invests in something pleasant and non-volatile that gains 6% a year.)

If our mythical investor realizes the capital gain every year - starts at $6,000 and rises slowly - then the marginal tax rate every year is half of 28.5%, which is close enough to my earlier 15% assumption that terminal value will be in the range of $450,000.

If instead the investor waits until age 65 to realize the gain, the pretax value is $575,000, the total gain is $475,000, the taxable gain is $237,000, and the marginal rate is half of 53.3%, again reasonably close to my 25% estimate earlier. I'm eyeballing this from the table, but it looks to me like the capital gains tax will be about $115,000, so the net amount left is $460,000.

The net annual after-tax return difference between these scenarios is less than 0.1%. It's not nothing but it is far different than Munger's scare story.

The point I'm making is that not using lower brackets every year, and then taking the full whack in an out year, is a lost opportunity. (The concept is not dissimilar to early stripping of an RRSP to avoid clawback, or quicker than normal withdrawals from a RRIF to avoid an enormous hit on a final return.)
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Re: Capital gains may be illusory.

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Norbert Schlenker wrote: 03 May 2017 11:35 (The concept is not dissimilar to early stripping of an RRSP to avoid clawback, or quicker than normal withdrawals from a RRIF to avoid an enormous hit on a final return.)
Yes. Or, on a related topic, using a RRSP as an income-shifting mechanism.

RRSPs were introduced as a saving-for-retirement vehicle, and that is mostly what they are used for. But they can also be very effective in shifting income from a high-effective-tax rate year to a low-effective-tax rate year. An example is taking a year off to go back to school or travel, and withdrawing a significant portion of one's RRSP in that year, at a very low tax cost. While you do sacrifice tax-deferred growth inside the RRSP, in many situations you will come out ahead. Income-shifting is the reason I first opened an RRSP in 1974. Retirement, and saving for it, wasn't even on my radar at that time.

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Re: Capital gains may be illusory.

Post by Shakespeare »

using a RRSP as an income-shifting mechanism.
Now that TFSAs are large enough to be useful, I have found them very handy in that regard.
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Re: Capital gains may be illusory.

Post by IdOp »

Norbert Schlenker wrote: 03 May 2017 03:53 while lump sum taxation gets you:

$10,000 x (1 + .06) ^ 30 x (1 - 0.25) = $43,076
Isn't this taxing the initial capital in addition to the gain? :?
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Re: Capital gains may be illusory.

Post by longinvest »

IdOp wrote: 03 May 2017 12:50
Norbert Schlenker wrote: 03 May 2017 03:53 while lump sum taxation gets you:

$10,000 x (1 + .06) ^ 30 x (1 - 0.25) = $43,076
Isn't this taxing the initial capital in addition to the gain? :?
Norbert copied my mistake... My bad. :oops: I fixed my post.
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Re: Capital gains may be illusory.

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Norbert,
Norbert Schlenker wrote: 03 May 2017 11:35 If our mythical investor realizes the capital gain every year - starts at $6,000 and rises slowly - then the marginal tax rate every year is half of 28.5%, which is close enough to my earlier 15% assumption that terminal value will be in the range of $450,000.

If instead the investor waits until age 65 to realize the gain, the pretax value is $575,000, the total gain is $475,000, the taxable gain is $237,000, and the marginal rate is half of 53.3%, again reasonably close to my 25% estimate earlier. I'm eyeballing this from the table, but it looks to me like the capital gains tax will be about $115,000, so the net amount left is $460,000.

The net annual after-tax return difference between these scenarios is less than 0.1%. It's not nothing but it is far different than Munger's scare story.
This investor looks pretty mythical to me, effectively. I have the impression of chasing a unicorn.

Realizing the entire capital gain in a single year, just to bump up the marginal tax rate, still doesn't give an edge to the early harvesting scenario. This same investor could keep his marginal tax rate much lower by simply taking yearly withdrawals all retirement long, instead. In other words, a young investor trying to keep his options open would be better to let capital gains accumulate. Later, he'll be able to withdraw the money in a lump sum with no worse effect than having harvested all along, or simply take regular smaller withdrawals and get to keep way more money in his pockets.

In the end, it is up to each investor to consider his own situation with a proper mathematical evaluation of his options, and make his decisions. All I tried to do was to explain how I go about it (with a couple a mistakes which were identified and fixed, thanks to IdOp's sharp eyes).
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Re: Capital gains may be illusory.

Post by Norbert Schlenker »

IdOp wrote: 03 May 2017 12:50
Norbert Schlenker wrote: 03 May 2017 03:53 while lump sum taxation gets you:

$10,000 x (1 + .06) ^ 30 x (1 - 0.25) = $43,076
Isn't this taxing the initial capital in addition to the gain? :?
:oops: I'm going to leave the incorrect math above (correct is $10,000 x ( 1 + ((1 + .06)^30 - 1) x (1 - 0.25))) = $45,576, which turns out marginally better - 0.06% per annum - than annual realization of the gain. So long as everyone realizes that I can "fix" that advantage by going to 5% annual returns, I trust this mea culpa will suffice.
longinvest wrote: 03 May 2017 13:09 Norbert,
Norbert Schlenker wrote: 03 May 2017 11:35 If our mythical investor realizes the capital gain every year - starts at $6,000 and rises slowly - then the marginal tax rate every year is half of 28.5%, which is close enough to my earlier 15% assumption that terminal value will be in the range of $450,000.

If instead the investor waits until age 65 to realize the gain, the pretax value is $575,000, the total gain is $475,000, the taxable gain is $237,000, and the marginal rate is half of 53.3%, again reasonably close to my 25% estimate earlier. I'm eyeballing this from the table, but it looks to me like the capital gains tax will be about $115,000, so the net amount left is $460,000.

The net annual after-tax return difference between these scenarios is less than 0.1%. It's not nothing but it is far different than Munger's scare story.
This investor looks pretty mythical to me, effectively. I have the impression of chasing a unicorn.

Realizing the entire capital gain in a single year, just to bump up the marginal tax rate, still doesn't give an edge to the early harvesting scenario. This same investor could keep his marginal tax rate much lower by simply taking yearly withdrawals all retirement long, instead. In other words, a young investor trying to keep his options open would be better to let capital gains accumulate.
As a general rule, yes. We're in agreement.
Later, he'll be able to withdraw the money in a lump sum with no worse effect than having harvested all along, or simply take regular smaller withdrawals and get to keep way more money in his pockets.
It sounds like you're agreeing with me that taking advantage of the progressive rate structure, a free option which expires worthless if unused each year, can make sense.
In the end, it is up to each investor to consider his own situation with a proper mathematical evaluation of his options, and make his decisions.
Agreed.
All I tried to do was to explain how I go about it (with a couple a mistakes which were identified and fixed, thanks to IdOp's sharp eyes).
Both of us caught by IdOp. I think we should delegate calculation to him from here on. ;)

By the way, I'm going to refer back a year and a half to this worry of mine re a change in inclusion rate, which remains on the radar if the pre-budget chatter earlier this year is any hint. If Morneau resorts to that, all of the math above goes out the window. Intuition fails me on whether that would favour annual or lump sum realization in the long run, and I don't have time right now to do the calculations (calling IdOp!!!).

Personally, I'm continuing the prophylactic course I began late in 2015, taking as much advantage as I can of what I consider historically low marginal rates on capital gains. Between Morneau and the possibility of the NDP forming a government in BC in a week, I still consider it prudent.
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Re: Capital gains may be illusory.

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Norbert Schlenker wrote: 04 May 2017 10:39 Personally, I'm continuing the prophylactic course I began late in 2015, taking as much advantage as I can of what I consider historically low marginal rates on capital gains. Between Morneau and the possibility of the NDP forming a government in BC in a week, I still consider it prudent.
It is a scary proposition. I am currently managing my MTR as well through judicious realization of cap gains, albeit not much (enough) right now. Off-topic for this thread, but I am resigned to setting up an endowment though for an in kind contribution to really manage the monsterous cap gain bill upon my death.
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Re: Capital gains may be illusory.

Post by IdOp »

Norbert Schlenker wrote: 04 May 2017 10:39I trust this mea culpa will suffice.
For sure; it's all too easy for these things to happen.
Norbert Schlenker wrote: 03 May 2017 11:35 I think we should delegate calculation to him from here on. ;)
My preferred capital gains inclusion rate is 0. Under that assumption I think the two scenarios will be a wash. ;)
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Re: Capital gains may be illusory.

Post by longinvest »

Norbert,
Norbert Schlenker wrote: 04 May 2017 10:39 Personally, I'm continuing the prophylactic course I began late in 2015, taking as much advantage as I can of what I consider historically low marginal rates on capital gains. Between Morneau and the possibility of the NDP forming a government in BC in a week, I still consider it prudent.
The impact of an increase in inclusion rate would, effectively, be quite bad. The Liberals have not completely evacuated this possibility. There's also Maxime Bernier (Conservative candidate) promising to eliminate capital gain taxes. It is difficult to predict the future. :?

Personally, I think that an increase in inclusion rate would be unfair. I already consider the current taxation of interest and dividends unfair, as it does not account for the loss of purchase power to inflation.
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