How to handle a stock with a huge capital gain

Here are five things you should think about when a capital gain could be significant, and some solutions investors can consider.

1. The break-even return for a replacement stock

The break-even return is worth considering if you are on the fence about paying tax to sell an investment. 

Imagine you own a stock that you purchased for $10,000 and is now worth $20,000. There is a $10,000 deferred capital gain. If we assume you are in a 35% marginal tax bracket, the tax payable on the sale of the stock would be $1,750.

That tax would be 8.75% of the sale price in this example. That is, $1,750 divided by $20,000 would disappear to tax. That means you would keep 91.25 cents on the dollar after tax, or $18,250 of the $20,000 sale proceeds.

If you did not sell the stock and it grew at 6% per year for the next 10 years, it would be worth about $35,817 pre-tax and $31,299 after-tax. For simplicity, this assumes the same 35% marginal tax rate for the entire capital gain.

If you sold today, paid the accumulated tax today, and then reinvested into another stock, your rate of return would need to be about 6.44% to have the same after-tax proceeds in 10 years. In other words, you would need to earn about a 0.44% higher rate of return on a replacement investment to be in the same position.

Do you think my 6% return assumption is too low? If we use 8% instead, the replacement investment would need to earn 8.54%, or 0.54% more, so not much different.

Do you think my 35% marginal tax rate is low based on your own situation? A higher tax rate would push up the required return slightly to compel you to sell. But the point of this example is to be careful about thinking you cannot possibly sell a stock because the capital gains tax is too high, and you will be worse off in the future for doing so. The break-even return may be lower than you think.

2. Diversifying your other holdings

Holding an investment longer just to defer capital gains can be particularly worrisome if the stock in question becomes, or has already become, too big a position size, meaning too large a part of your portfolio.

This risk is especially applicable in retirement, when you may be drawing down your assets. If you are withdrawing money from other investments and avoiding selling a specific stock, its percentage allocation relative to your total portfolio could increase and cause you to become less diversified over time.

The bare minimum number of stocks you need to have a diversified portfolio is generally considered to be 20, according to academic studies. Some experts contend it should be higher. After 30 or 40 stocks, the incremental advantage of a 31^st or 41^st stock becomes smaller and smaller, from a diversification perspective.

That does not mean that an index fund with hundreds or even thousands of holdings is over-diversified or not a good investment strategy. It just means that if you are going to buy individual stocks—and deal with the cost and complexity of doing so—you may not want to own hundreds or thousands directly.

If a 20-stock portfolio is already a lean portfolio, that implies a 5% allocation to each holding (100% divided by 20 stocks). As a result, my own rule of thumb for when a stock allocation is getting too large within a portfolio is when it rises over 5%. So, if a stock is more than 5% of your portfolio, you should be cautious about letting it become a much larger allocation.

For me, there should definitely be a trigger at 10%. This may be the point when you consider selling in order to avoid single-stock risk.

3. Taking advantage of low tax brackets

A taxpayer’s income may vary from year to year for different reasons. This is especially common early in retirement, but it may happen for other reasons—for example, self-employed sole proprietors often have fluctuating income.

Regardless, if someone expects to be in a higher tax bracket in the future, a low-income year can be an opportunity to have income taxed at lower tax rates. This can include triggering strategic capital gains by selling an investment. 

4. Fully using your RRSP room

If you have room in your registered retirement savings plan (RRSP), you can make RRSP contributions to offset capital gains. Even if you are retired, and not otherwise making RRSP contributions, if you or your spouse are under age 71, you can contribute to an RRSP if you have contribution room carried forward.

Selling a non-registered investment that has doubled in value would result in no more than about 13% tax payable on the total proceeds in most provinces and territories. By comparison, using those same proceeds to make an RRSP contribution could save over 50% tax. As a result, selling a non-registered investment when you have RRSP room can result in a significant short-term tax win.

5. Donating shares for tax benefits

If an investor donates shares or other securities with deferred capital gains directly to a charity, there are dual tax benefits. 

• There is no capital gains tax payable on the proceeds. 
• The fair market value of the shares at the time they are transferred to the charity results in a donation tax credit, just as if the donor gave the equivalent amount in cash.

The tax savings from a donation can be up to about 50% depending on the taxpayer’s income and province or territory of residence. And if you consider the tax payable avoided due to the capital gain being excluded from income, the tax savings could be well over 50%.

If a taxpayer is philanthropically inclined or making donations anyway, an in-kind security donation should be considered. It would not make sense for a $25 donation, but if you’re considering a larger donation, it can be worth the paperwork involved. Many charities accept donations of securities, so just ask them.

Other considerations

There are more elaborate strategies to diversify away from a stock that has significant deferred capital gains, like borrowing against the value to avoid triggering tax and using the proceeds to invest in more diversified stocks. But some of the simpler considerations above are probably more pertinent for most investors.

Capital gains are a good thing and better than the alternative of capital losses. Paying tax on those gains may not be appealing, but if selling is the cost of diversification or simply seeking better investment options, it should be considered. By planning how to mitigate capital gains tax, an investor can also keep more of their stock proceeds.

Read more from Ask a Planner:

• How can couples avoid capital gains tax on property in Canada?
• Tax implications of giving your spouse money to invest
• How is investment income taxed in Canada?
• Planning to use your home equity in retirement

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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