Rebalancing a portfolio: Is doing nothing … doing something?

A Seinfeld inspired tax insight on staying the course

None of us will look back on the COVID-19 pandemic with a feeling of nostalgia. Apart from the health dangers, many struggled with self-isolation and social distancing. Still, for many families like ours, we cherished the opportunity to re-connect in ways we hadn’t in years, like dusting off board games, semi-regular family walks, and catching up on some classic TV, like Seinfeld.

In fairness, the show had a bit of a slow start, but it didn’t take long for it to hit the stride that took it to the top over its ten-year run. Now more than three decades since it hit the air, there really is something about the sitcom that came to be known as a show about nothing.

That worked in the world of sitcoms, and may give us something to consider in dealing with investment portfolios.

A conscious nothing

I’m certainly not suggesting that investors set up portfolios once, and ignore them thereafter. On the contrary, it’s imperative to be conscious of economic developments – such as how a global pandemic can derail global financial markets – as well as any developments in the businesses behind individual securities held.

The investor can look to her financial advisor as a source of this kind of information. Together they can review the information to determine what’s relevant (including the effect on the investor’s appetite for risk) and decide if adjustments are warranted. Those may be portfolio changes, behavioural changes, or both – or nothing at all.

The critical point is to resist the urge to make change for the sake of change alone.

Nothing and taxes

That urge to ‘just do something’ can be particularly harmful to a non-registered portfolio. Unlike registered accounts, changes to non-registered holdings can result in taxable dispositions. Tax deferral that an investor enjoyed while holding rising securities over the course of years will be realized when those securities are sold.

If those portfolio changes are based on an informed and focused review, then the tax implications should not stand in the way of taking that action. However, if the original portfolio continues to suit the investor’s planning needs then a premature change not only drifts away from the plan, but also compounds that diversion by triggering taxes unnecessarily.

This was complicated enough over the last couple decades or so since 2000 when half of capital gains were taxable. Then came the 2024 Federal Budget that increased the inclusion rate to 2/3 of realized capital gains, while preserving the 1/2 rate on the first $250,000 of an individual’s capital gains in a year. For modest portfolios, this change will have little effect on decisions, at least for now. But as compounding continues over many years and decades, this dual-rate structure will become more of a factor in portfolio decisions.

A tale of two investors – Gerry & Jorgé

Consider sister and brother investors, Gerry and Jorgé, 40-year-old fraternal twins saving for a big trip together for their 50th birthday. Both are high income so we’ll assume a 50% marginal tax rate, while using the 1/2 capital gains inclusion rate as neither expects significant capital gains any time soon.

Ten years ago, each used $10,000 to buy 1,000 units of VanDelayed mutual fund for $10 per unit. The price rose as high as $18 but has since come back to $14. It pays no dividends. Despite the recent price decline, Gerry leaves her investment alone.

Jorgé, on the other hand, is convinced that VanDelayed will continue to fall, so he sells. With a fair market value of $14,000 and a $10,000 adjusted cost base, he realizes a $4,000 capital gain. As half the capital gain is taxable, he has a $2,000 taxable capital gain that costs $1,000 in tax, leaving him with $13,000.

A couple months later Jorgé reconsiders and decides that Gerry was right. As it turns out, the price is again $14 when he reinvests his $13,000.

Ten years later when it’s time to book the trip, VanDelayed is at $28.

- Gerry’s $28,000 holding realizes a $18,000 capital gain, resulting in $4,500 in tax, netting to $23,500.
- With the price doubling from $14 to $28 from the time Jorgé reinvested, his $13,000 rose to $26,000. Taking away $3,250 tax due to the $13,000 capital gain, Jorgé is left with $22,750.

Despite that Jorgé got back in at the same price as when he exited, the early tax payment hampered his growth, in this example putting him $750 behind Gerry. And though the amount of difference would vary depending on the growth rates at the two time points, as long as there was growth then the difference would never come out to nothing … which is something to think about.

SWPs – Systematic withdrawal plans

Tax treatment of non-registered account decumulation

During accumulation, investors enjoy a tax deferral when the price of their holdings increases. In tax terms, this is known as an unrealized capital gain, and works whether securities are held directly or within a mutual fund. In this article, we’ll use mutual fund examples and terminology.

Later, if the money is not needed all at once, it will usually be taken as a series of annual draws, known as a systematic withdrawal plan (SWP). This spreads the tax by allowing continuing deferral on the remaining investment.

Tax deferral with unrealized capital gains

In registered accounts such as Registered Retirement Savings Plans (RRSPs) and Registered Retirement Income Funds (RRIFs), investors are entitled to tax-sheltered growth regardless of the type of income that is earned. There is also no tax as the investment value varies, but when withdrawals are taken, each dollar is fully taxable.

For non-registered accounts, interest and dividends are taxable in the year earned, as are capital gains that a mutual fund realizes and distributes to investors. Changes in the price of underlying securities will cause a mutual fund’s value to change, but no tax arises out of such fluctuations. But when there is a redemption/sale of the fund by the investor, that is a taxable event. And if the fund’s value has increased in the interim then the investor will realize a capital gain at that time. That capital gain is equal to the fund’s fair market value (FMV) minus the investor’s adjusted cost (ACB), the latter being discussed in greater detail under the next heading.

Fortunately, only a portion of the capital gain is taxable. The “taxable capital gain” is derived by applying what is known as the income inclusion rate. That rate has ranged between 1/2 and 3/4 since 1971, but has remained stable at 1/2 since 2000. Now, in accordance with the 2024 Budget, the rate has again risen to 2/3, but the 1/2 rate remains available for individuals on the first $250,000 of capital gains in any year. (For trusts and corporations, the 2/3 rate applies to all capital gains.) The 1/2 rate is used in the examples to follow, on the assumption that the investor is an individual with less than $250,000 of annual capital gains.

Adjusted cost base

An investor’s ACB begins with the amount invested, averaged across multiple purchases. For example, if one mutual fund unit was purchased last year for $4, and one unit this year for $6, the total ACB is $10, which works out to $5 average per unit. The total value as of the second purchase is $12, including an unrealized capital gain of $2.

The “adjusted” part of ACB includes such things as acquisition costs on each transaction, and income that is not distributed but instead reinvested. Notably, the investor is still taxed on reinvested income as if it had been distributed, with the ACB increase ensuring that the investor is not taxed a second time on a later disposition.

Redemption, portion, proportion

As a capital gain is an addition to invested capital, you could think of it as a chocolate-dipped soft ice cream cone. When it comes time to consume it, you could be taxed as if you licked off all the chocolate first (that’s the added portion), or each bite could be treated as some ice cream and some chocolate.

Eating preferences aside, it is the latter biting version that more closely resembles a mutual fund redemption. Each redemption has two portions: ice cream in the form of a non-taxable return of capital (ROC), and chocolate dip that is treated as a realized capital gain. The proportion of each on a given redemption is based on the size of the redemption in relation to the ACB and the current market value. This is best illustrated by looking at a few scenarios.

SWP scenarios

Suppose you inherit $100,000 from a great aunt and decide to use it to supplement your monthly income by $500, or $6,000 annually. You choose a mutual fund you expect to earn a consistent 6% annual return, all in unrealized capital gains. To keep the focus on the SWP effect, we’ll simplify the arithmetic by having you take your withdrawal at year-end rather than monthly. Your marginal tax rate is 40%.

Scenario 1 – Equal withdrawals, maintaining principal

In this first scenario you intend on preserving that $100,000 for your children, so you’ll take withdrawals equal to the investment return. Here’s what it looks like in the first year, with figures rounded to the nearest dollar:

After that first-year withdrawal, the ACB is reduced to $94,340 to account for the $5,660 ROC, but you still have $100,000 invested. The second year’s withdrawal will net to $5,868, for an effective tax rate of 2.2%. It will take over 100 years for the effective tax rate to round to the actual 20.0% rate on taxable capital gains.

Though you will have maintained the principal amount invested, the continuing reduction in the ACB means that an increasing portion of your investment will be taxable. If you never sell, there will still be a deemed disposition at your death (though this could be deferred by rolling it at ACB to your spouse), before passing on to your children as desired.

Scenario 2 – Equal spendable withdrawals, depleting principal

Instead of allowing the net withdrawal to be reduced each year, you may prefer to have a consistent after-tax spendable amount. If you want $6,000 in your hands, you would need to withdraw/redeem more than that in order to account for taxes. That would only be another $69 in year 1, but the extra amount would increase each year.

While this slowly depletes the principal, even at year 25 you will still have about $70,000 invested.

Scenario 3 – Indexed withdrawals, eventually exhausting principal

As the years roll on, the flat amount of withdrawals under either of the preceding scenarios will lose purchasing power due to inflation. Rather than passing on the principal to your children, your priority may be to use this money to take care of your own living expenses. To do so, you could index the withdrawals each year.

The current inflation rate recommended in the 2024 FP Canada Projection Assumption Guidelines is 2.1%. At that rate, you could sustain an indexed $6,000 spendable withdrawal from $100,000 of principal for about 25 years.

Who gets the family cottage … and how?

Holding onto memories while letting go of ownership

Some of the hardest estate planning decisions are not about dollar values, but about personal values. A prime example is the family cottage, where the memories are many, and the mere mention of letting-go can be painful.

Unfortunately, it’s not much easier on parents who intend to keep it in family hands rather than sell to strangers. Among those you love, it can be even more emotionally troubling to decide when, how and to whom ownership will pass.

To prepare for these tough choices, it’s helpful to have a clear understanding of tax and legal rules so that you can anticipate hurdles and consider options.

Tax liability for parent as seller/transferor

Apart from spousal transfers, a change in beneficial ownership is a taxable disposition. Half the increase in value from the adjusted cost base (ACB) to the fair market value (FMV) is added to the seller/ transferor’s income for that year. The ACB is generally the acquisition price plus capital improvements.

The tax bill could be reduced by claiming the principal residence exemption (PRE), though that would limit use of the PRE on a future disposition of other concurrently owned residential properties.

Options for passing ownership to one or more adult children

In an arm’s-length sale, a seller transfers ownership without control or concern as to how that arm’s length purchaser holds title. In family situations, there are more options that parents may consider:

Direct transfer to one child

Even if little or nothing is paid in return, a full disposition is deemed to occur at FMV for purposes of calculating the capital gain. Thereafter, the child has all rights of ownership.

Adding joint owners

A proportionate disposition is deemed for each added owner. For example, a widowed mother who adds 2 sons is deemed to dispose of 2/3 of the value. The later death of any joint owner is a disposition of that person’s share, with the survivors continuing to own the property together.

Using tenancy-in-common

A parent could direct a specified percentage to transfer to one or more children, to be held as a tenant-in-common. Like joint tenancy, there is a disposition on initial transfer and on an owner’s death, but the deceased’s rights pass to his/her estate, not to the surviving owners.

Tax-deferred trust transfer

Parents over age 65 could transfer the cottage into an alter ego or joint partner trust for their current benefit, with the children as contingent beneficiaries. The property is not deemed disposed until both spouses die, at which time capital gains would be calculated and tax due.

Transfer to a lifetime trust

The parents may be content to trigger a taxable disposition to a trust now. They could maintain legal control as trustees, with future gains accruing to the children as beneficiaries.

Estate distribution possibilities

If the cottage is held to the second spouse’s death, the capital gain arises at that time. The cottage could then be transferred to the children (tenants-in-common or joint owners, as desired) or continue to be held in trust according terms as outlined in the last deceased’s Will.

Funding the tax liability

Allowing that the PRE may be claimed in some situations, tax on the capital gain is usually inevitable. And if it’s large, the decision may be to delay triggering it until death. Parents could buy joint last-to-die life insurance to pay the tax, or allow that other estate assets will have to be sold to raise the needed cash.