When to Realize Capital Gains in Retirement

Retirees can feel trapped by their own investment success: not wanting to realize capital gains but not wanting to leave a surviving spouse with a concentrated, risky portfolio.

Investors who have made capital gains in taxable accounts have to decide when to realize those gains and pay what is owing to the CRA. For savers, it usually makes sense to defer tax obligations because deferred taxes can be viewed as an interest free loan from the CRA to invest for further growth. For retirees, the situation is more complicated because the premature death of a spouse can leave the surviving spouse with a higher tax bill.

Many investors have enjoyed positive returns over the past decade, including those in and close to retirement. An investor who simply bought and held an S&P 500 index fund 10 years ago would have an unrealized gain of 240%. Holders of some individual stocks (e.g. Amazon, Shopify) have seen even larger gains.

When to realize capital gains emerged as an issue of concern at a meeting of investors (mostly male) who were self-managing their investments. They were reluctant to pay taxes that they could defer and to consider their own mortality (death and taxes!) but recognised that their investments had become concentrated with past winners which, in the event of their passing, might present underappreciated risks and an increased tax burden for the surviving spouse.

We consider the situation of a retired couple, Alice and Bob, where there are significant capital gains in a joint taxable account, and they also have pension income. Bob has a higher pension income than Alice but is likely to pass away first.

Our couple

Bob, age 71: $80,000 taxable pension income

Alice, age 71: $40,000 taxable pension income

Jointly held: $1 million taxable account with $400,000 (40%) in unrealized capital gains.

To keep our model simple, we ignore future investment returns.

We consider two scenarios. In the first scenario (Hold Gains) Bob dies on his 76^th birthday without making any changes to the taxable account. In the second scenario (Realize Gains) the gains are realized over five years and then Bob passes away on his 76^th birthday.

Before reviewing the results of each scenario, we consider some of the underlying tax rules.  Pension income can be split between spouses for tax reporting, so the total pension income of $120,000 can be split so that both Alice and Bob report pension income of $60,000 each. In the absence of any other taxable income, income splitting saves Alice and Bob $405 annually (Ontario 2021 tax rates), compared to reporting separately.

We assume Alice and Bob contributed equally to assets in the joint account so split any taxable gains equally.

On Bob’s death we assume that 100% of his pension assets rollover into Alice’s retirement accounts. Pension rollover can depend on the type of pension and the choices available. A defined benefit (DB) plan may have survivor benefits that vary from 0 to 100%, while the Canada Pension Plan (CPP) has a complicated formula for capping a survivor’s CPP. RRSP/RRIFs typically have 100% rollover to the surviving spouse unless other beneficiaries are named.

For Alice and Bob, we seek to generate the same after-tax income in both scenarios and compare the total tax paid in each scenario.

Table 1 summarises the Hold Gains scenario.

Source: PWL Capital

In the first year Alice has pension income of $40,000 and Bob $80,000. They had determined that they need an annual after-tax income of $136,384 to fund their retirement. Alice and Bob need to withdraw $40,000 from their joint account to achieve this goal. The realised taxable gain from the $40,000 withdrawal is $40,000*0.4*0.5 = $8,000, so Alice and Bob’s total taxable income is $128,000.

When Bob passes away at age 76, Alice must pay more tax if she is to maintain the same household income because of the loss of income splitting. A higher tax bill requires withdrawing more from the portfolio, upon which she also must pay tax on the realized gains. Her tax bill increases by 56%.

Table 2 summarises the Realize Gains scenario

Source: PWL Capital

Alice and Bob pay more tax initially because they are realizing taxable gains while they can take advantage of income splitting. In each of the first 5 years they sell one fifth of the portfolio and reinvest the proceeds after deducting the amount need to maintain their income and paying taxes. By taking profits early, Alice and Bob can build a diversified portfolio suitable for generating retirement income.

After Bob dies Alice has no more capital gains tax to worry about (recall that we are assuming no investment growth) and the household tax bill declines by 3%.

In both scenarios Alice passes away at age 90. Perhaps surprisingly, the total taxes paid over the retirement period are slightly lower when capital gains taxes are realised earlier. The cumulative taxes paid in each scenario are shown in the chart below.

There are many factors that could change the outcome. For example:

• Alice may need less income so the withdrawal from the taxable account would be less.
• The rollover of Bob’s pension assets could be less than 100%, increasing the withdrawal from the investment account.
• Despite expectations, Bob may outlive Alice.

Our main observation is that that addressing unrealized capital gains early in retirement can be part of an overall strategy to leaving a surviving spouse with a well diversified portfolio more suited to their needs without necessarily incurring a tax penalty.