COVID Contemplations � Financial Planning During Difficult Times

In this eerie time of social distancing, medical mayhem and financial carnage, I feel like a background character in a cheesy made-for-tv movie starring B-grade actors from the 70s. Unfortunately, the chaos and risk are all too real, although the consequences and aftermath remain a riddle wrapped inside an enigma.

For those of you, however, who are trying make sense of their financial picture, I do have a few suggestions to lessen the financial pain and some things to keep in mind when you are deciding what to do next.

Consider Future Tax Issues When Making Your Financial Decisions Today

When reading some of the tax-planning options I discuss below, particularly those about harvesting capital losses, it’s also really important to consider how things might look a few years down the road when COVID-19 is, hopefully, a distant and not particularly fond memory, like door-to-door salespeople and (fingers crossed) manbuns. I simply can’t imagine a future that doesn’t include significant tax hikes, particularly for those in the higher tax brackets or for most people in their year of death. I also worry if this might also include increasing the inclusion rate for capital gains from 50% or, for those of you not up on tax-speak, what percentage of any realized capital gains is actually included as taxable income and what part is tax-free. Keep in mind that this was something tax types were stressing about even before this all came down.

In the past, as much as 75% of capital gains were taxed when an investment was sold. If the inclusion rate goes to 75% again, this would mean paying 50% more tax on gains than we are right now! For example, if you had a $10,000 capital gain and were in the 40% tax bracket, you’d have to pay $2,000 in tax at the 50% inclusion rate ($10,000 x.50 x.40). If it goes to 75%, then you’re out of pocket $3,000 ($10,000 x .75 x.40). Hopefully, if the inclusion rate is increased, it’s not quite so drastic—I just used 75% as an example since it was a number our government had charged previously. Essentially, just like when setting any other tax rates, they can pick any number they want, limited only by the fact that they want to get re-elected and probably don’t particularly enjoy having their likeness burned in effigy.

A. Capital Gains

For those of you with unrealized capital gains from those bank stocks you bought in the days of disco, there are some planning opportunities available for you, particularly if you expect to be in a lower tax bracket than usual this year anyway. Here are some of the reasons why you might want to trigger some of those gains now:

Your other sources of income are also affected this year and you’ll be in a lower tax bracket than usual. Although paying taxes ahead of schedule is not something I love doing, you might be better biting the bullet now vs. selling in a few years during the new tax reality. It may also mean not having as much money in the market to capture any future market recovery and receive dividend payments if you have to divert some of your capital to pay the tax bill next year unless you have offsetting capital losses so consider this carefully. On the other hand, it’s not like you need to pay the tax bill today —this is a bill you won’t need to cover until April 2022.
You have other stocks that are underwater and would generate capital losses upon sale. You could apply those losses against those gains so you won’t have to pay the tax man this year and can keep all of your capital invested to, hopefully, participate in any recovery and generate income while you wait.
You have losses from previous years already on the books to use so you won’t actually be triggering a tax bill. Triggering gains at the current inclusion rate, even if you aren’t actually paying any tax on them because of your offsetting losses, will still save you tax in the future if inclusion rates change going forward.
You are worried and were going to take some money off the table anyway.
Your portfolio wasn’t properly diversified, previously, it would have meant paying too much tax to rebalance previously. Now that values might have declined, that tax bill isn’t so high, and the tax pain isn’t too great. Although you are selling when markets are down, you will also be purchasing your new investments at a discount. This works even better if you have some of those offsetting losses we also discussed.
Your risk tolerance has changed, or you no longer like your current mix of investments anyway.
Your capital gains are inside your company and you are really worried about the inclusion rate for gains increasing going forward. If this happens, corporate investors will suffer another hit. Our tax system allows companies to pay out the non-taxable portion of capital gains tax-free to its shareholders (i.e. currently the 50% that isn’t taxed). If the inclusion rate went to, say, 75%, then shareholders would only be able to take out 25% of the gain tax-free, which is half of what they can do now. When coupled with the higher tax rates we’ll likely be paying in general going forward, this might be enough incentive to lock in those tax-free payments now, particularly if the business owner isn’t making as much money from other sources that year anyway. If this might be you, then you might hold off selling company-owned investments that have losses, as realized losses offset how much of the gains you can withdraw tax-free.
You are looking at other uses for your money, such as permanent life insurance, income-splitting it with a spouse or through a family trust, paying down debt or perhaps helping the children a bit more now than you’d previously anticipated.

As a final point, it is also important to remember that if you do sell a stock that is in a capital gain position but you still love it, there is nothing that stops you from buying it back whenever your heart desires. Although you must wait 30 days after selling a loser before repurchasing it, there is no such rules when reconnecting with a former flame that you previously sold at a profit.

B. Capital Losses

When deciding whether to trigger capital losses, here are some of the things to keep in mind when making decisions:

If tax rates and the inclusion rate both increase in the future, triggering capital losses in later years to offset future gains might save you more money over time than triggering them now, particularly if you’re ultimately going to be in a higher tax bracket in the future anyway.

We talked earlier about how the inclusion rate works for capital gains and how an increase of the inclusion rate from 50% to 75% would mean including $7,500 of every $10,000 capital gain as taxable income rather than just $5,000. The same is true for capital losses—if the inclusion rate was increased from 50% to 75%, this means that you get to deduct $7,500 per $10,000 of bad decisions rather than only $5,000.

It all comes down to when you trigger the losses. Typically, when inclusion rates are increased, those increases don’t apply to losses already on the books. For example, if you trigger a $10,000 gain in a dystopian future reality where inclusion rates are 75% but had an unused $10,000 capital loss on the books from this year, the two would no longer cancel each other out. Because you triggered the loss at a time when the inclusion rate was only 50%, you would only get to deduct $5,000 of that total loss of $10,000 but had to include $7,500 of the $10,000 gain as income, meaning you would still need to pay tax on $2,500. It’s always possible that the government could increase the inclusion rate for past losses if they decide to increase the inclusion rate for new gains. Personally, I think it’s more likely to find discount hand sanitizer and toilet paper on sale next week than for that to happen.

If you want to trigger capital gains this year for some of the reasons discussed above, e.g., you’re going to be temporarily in a lower tax bracket and are okay paying some tax now at current rates, you won’t want to trigger any capital losses this year, as they have to applied against this year’s gains.

Triggering losses now will give you more flexible for rebalancing your non-registered portfolios going forward since you can apply these losses against future gains so that you can rebalance without tax consequences until those losses are used up.

You have some big capital gains from the last 3 years and want to carry back this year’s losses to get back some of last year’s taxes. You’ll have to wait until you file your 2021 tax return to do this, but it might be worth the wait if you were in a high tax bracket then and don’t expect to be in the same place going forward.
- You adopt the bird-in-the hand approach and want to deal with today’s taxes and inclusion rates rather than guessing about how things might look in the future. Likewise, you might expect some of your losers to rebound and might want to just lock in the losses now for flexibility’s sake, even if this means having more taxable capital gains in the future if your reinvested dollars make money.

As a final thought, it is important to remember that you, your spouse, your company, etc. must wait 30 days to repurchase any investments you sell in order to be able to realize your capital loss. If you are still really bullish on the investment’s long-term future, then you could look at similar alternatives, at least until the 30 days have expired, unless you’re happy to sit on the sidelines for the short term.

C. Find Some Balance

Somewhat ironically, some of my client’s biggest financial planning headaches this time last year were not being able to rebalance their portfolios without triggering big tax bills. In many cases, this meant having a disproportionately large share of their investments in perhaps a few stocks that had been in their lives longer than their children. Adding to the risk, many clients owned several similar stocks in the same sector with the same problem, such as perhaps 3 or 4 Canadian bank stocks they’d first started acquiring when the first Trudeau was doing his thing.

All that has now changed. Although you may still love your BMO or Royal Bank shares, it may now be possible to trim those positions in favour of a new infatuation. It doesn’t mean abandoning all of those legacy stocks, but merely hedging your bets. Although playing the field is not a great recipe for romantic success, investing is an entirely different kettle of fish. Rather than just looking at the tax side of things, you might be better off focusing on building a properly diversified portfolio that fits like a glove even if it means cutting an extra cheque to Ottawa in order to make this happen.

If you are looking to rebalance, perhaps this is the time to add a few new types of investments to your portfolio, particularly:

some that don’t trade on the stock market and hopefully haven’t taken as strong a gut punch to their prices as public market stocks have suffered.
expanding your portfolio geographically beyond just Canadian dividend-payers and some companies in the U.S.
investments that offer some downside protect through options or the ability to short-sell or which are designed to allegedly make money in any market conditions, although this doesn’t always happen.

The current buzzword is that people should “invest like a pension” and strive for less risk and smoother returns by expanding their mix of investments. Although even pension funds or companies that invest like them have taken a kick to the teeth this last month, their extra levels of diversification have generally helped them some of those extra body blows that the average Joe has endured.

D. Look To Refinance Loans

For those of us with mortgages, one of the consolation prizes (albeit one on par with a getting a participation ribbon for finishing 58th place in a five kilometer race) are much lower borrowing rates. If you have loans of any type, get professional advice regarding whether it makes sense to redo those loans at current rates despite any penalties that might apply. For those of us with variable loans, the monthly savings can be significant and will hopefully help ease the pain for years to come.

For those of us with family trusts and loans at two per cent, consider refinancing those loans at a new one per cent borrowing rat, as it appears likely that the minimum loan rate will drop back to one per cent at that time. This will also apply to spouse loans as well, so if your better half is paying you two per cent interest per year, consider updating this as well. Despite the hassle, it’s recommended that you actually physically repay past loans and then re-advance the funds. The only caveat to taking the plunge and making this happen is if there are significant capital gains owing on the investments that (s)he who must be obeyed or the trust would have to sell to make this happen and it doesn’t make sense to trigger them now despite my earlier comments on all things capital gains.

This will allow more future investment income to be taxed in low-income family members’ hands and less in yours at your higher rates.

E. Consider Setting Up A Family Trust Or A Spousal Loan

Since minimum required rates are now one per cent and can not get any lower due to the formula the government uses to calculate these things, if you haven’t used spousal loans or loans to family trusts to income split with your main squeeze and lower income children or relatives of any age, there may never be a better time. Noting the current yields on many investments and the hope of stocks eventually may recapture some of their past glories, the tax savings from loans to family investment trusts or spouses are even more mouthwatering. Until now, the unrealized gains on the higher income spouse’s portfolios may have been a deal-breaker, as it meant paying too much tax to free up the capital to loan to your spouse or trust. For better or for worse, this may no longer be the case, both because of reduced gains and perhaps if the higher income spouse is in a lower tax bracket this year.

F. Be Prudent If Investing New Money Into The Market Today

Although current yields on many investments are (apologies to my vegetarian, vegan or pescatarian readers) as mouthwatering as prime rib on a cold winter’s day, there is still a lot of uncertainty in the market. Although it is a personal decision whether you wish to deploy any dry powder you may have to take advantage of these eye-popping yields, do keep in mind that we might not have seen the bottom, and it’s hard to determine how the fallout will affect different stocks and industries. Consequently, keep in mind some of the following if you’re contemplating dipping a toe back into today’s rather frothy investment waters:

Consider dollar cost averaging rather than trying to do market timing. We don’t know if we’ve hit the bottom, so you may benefit from easing money back into the market over a number of weeks or months rather than going “all in” on what your fortune teller says is your lucky day.
Yield is a wonderful thing. If you do want to put new cash into the market, take advantage of those high yields rather than counting on future gains. The income will reduce the risk and can be redeployed back into the market if you so desire, or can be a way of providing more money for your family during a time when many family budgets will be stretched extremely thin. Because of the current calamity, even blue-chip stocks have yields formerly reserved for junk bonds. As a result, there is no need to travel too far down the risk spectrum just to get a few more percentage points when safer stocks are already paying you handsomely.
Be sure that you have a sufficient contingency fund set aside to cover you and your family’s expenses so you’re not stuck having to sell some of those investments you just purchased at the worst possible time. If in doubt, bump up the size of the contingency fund.
Be even more conservative if you are borrowing to invest. Although rates are astonishingly low right now, leveraged investing only works if you can pay back your loans when the time comes. Accordingly, think long and hard before proceeding and reread my last three bullets at least twice. I strongly suggest staying away from margin accounts at this point, as a margin call might ultimately be the financial kiss of death. If you do borrow to invest, carefully investigate the spread between secured lines of credit and borrowing using a traditional mortgage. Despite the decrease in rates, there can still be a big difference in cost between borrowing using a household line of credit or using a mortgage. Although the mortgage option is less flexible and requires you to also pay down some of the principal with each payment, it might still be the way to go.
Diversify, diversify, diversify. Because the fallout is still so uncertain, spread your money over many different sectors and investments. It’s better to take some of the risk off the table by hedging your bets. Rather than waiting for fair weather and your ship to come in, consider funding a fleet of smaller boats that will see you safely into the future even if some of them don’t ever reach the shore.

G. Look Into Estate Freezes

An estate freeze is a strategy that involves owners of private companies swapping their common shares for fixed value preferred shares. New common shares are then issued to other family members or to a family trust, and all future increases in company value will be taxed in their hands. Private business owners do this sort of thing this for a couple reasons:

To increase how much capital gains can be sheltered from tax if the business is sold. If the existing shareholders won’t be able to shelter all the gains from tax upon sale under their own lifetime capital gains exemptions, having new growth taxed in other’s hands allows these other family members to dip into their own exemptions to increase tax sheltering at that time.
To minimize the tax bill on their deaths by capping the value of their shares and transferring future growth to younger generations.

Despite not owning a private company, are you the proud owner of a non-registered investment or real estate portfolio that you want to pass along to your kids, grandkids or favourite financial planner? An estate freeze might still be the thing for you. Transferring those assets into your company on a tax-free rollover basis in exchange for fixed value preferred shares lets any future growth accrue inside a family trust or in your heirs’ hands rather than yours. As a result, when your time comes, you can pass into the great beyond knowing that your final tax bill is a lot smaller and your heirs’ inheritance that much larger than might have been the case.

In most of these instances, estate freezes only work if the new common shares subsequently grow in value. Accordingly, doing a freeze this year when share prices for most private and public companies are at Black Friday prices can mean tremendous tax savings in years to come if values do bounce back, particularly if tax rates and the inclusion rate are both higher in the future.

H. Learn About Your Options

Keep informed about government programs and tax changes that might help you and your family, such as Employment Insurance (EI), reduced Registered Retirement Income Fund (RRIF) withdrawal requirements, extensions to tax filing and installment payments, changes to your bank rates, mortgage or loan deferral options and so much more.

Conclusion

I am hoping that one day, hopefully soon, we can look back on today’s events in the same way many of us look back on 2008 and 2009 and perhaps how my parents viewed my teenage years—incredibly trying and stressful, but something we all survived and put behind us. I’ve tried to give you a lot to think about but there are so many moving parts and uncertainty that this is probably a good time to get professional advice before taking any big steps. In the meantime, let’s just focus on being good to each other and realizing that we’re all in it together.

Colin S. Ritchie, BA.H. LL.B., CFP, CLU, TEP and FMA is a Vancouver-based fee-for-service lawyer and financial planner who does not sell investment or insurance, just advice. To find out more, visit his website at www.colinsritchie.com.