Taking capital gains or losses now to avoid estate and probate fees later

Investment Insight

Selling an asset in a capital loss position can provide immediate tax savings by offsetting current year capital gains or by recovering taxes paid on capital gains in any of the three previous years.

However, the idea of triggering capital gains by selling assets that have grown in value is one investors typically don’t welcome. It generates a tax bill and reduces the amount of capital that can be used to invest and benefit from compound growth.

Yet, in some scenarios, it can make sense to trigger a capital gains tax bill now to take advantage of the wealth transfer benefits of segregated fund contracts and/or insurance company issued guaranteed interest contracts (GICs) to potentially increase the final value of your estate.

The Case

Let’s assume you’re a 70-year-old business owner who wants to pass on as much as possible to your beneficiaries.

Current mutual fund portfolio

$1,000,000   Market value
$900,000     Adjusted cost base (ACB) — for tax purposes
$100,000      Capital gain

The Proposal

Your advisor recommends you sell your mutual fund (which is in a gain position) today and pay the capital gains tax so you can invest in a segregated fund contract. Where a beneficiary other than your estate is named, this strategy allows your investments to avoid your estate and the resulting legal, estate administration, and probate fees¹ while enabling a private2 and fast transfer of wealth to your beneficiaries.

The following examines this scenario in more detail.

Current Mutual Fund Portfolio

Capital gain $100,000
50% income inclusion $50,000
Tax payable³ at 40%   $20,000
Net amount to invest (market value - tax payable) $980,000
 

Generating a $20,000 tax bill isn’t preferable; however, that’s not the real concern here as it will have to be paid eventually. Your main concern is the cost of pre-paying this tax — that’s the opportunity cost of losing potential growth on the $20,000. In addition, there are usually incremental costs associated with a segregated fund contract, relative to the mutual fund, that can lower the rate of growth. Assuming a 5% rate of growth for the mutual fund and 0.3% segregated fund incremental cost, over a 10-year period, the mutual fund would grow to $1,628,895 compared to $1,551,290 for the segregated fund contract.
 

While $77,605 is a significant difference between market values, there are cost savings a segregated fund contract can provide at death over a portfolio of mutual funds (or stocks or other investments). For a true comparison, factor in the additional costs for the transfer of wealth from your estate if you kept your mutual fund. The table below shows only projections. The actual costs may vary based on your individual situation.

 

Mutual fund

Segregated fund

Market value at death

$1,628,895

$1,551,290

Probate fees4

$23,683

$0

Legal, accounting, and executor fees

$56,367

$0

Total estimated fees

$80,050

$0

Income taxes

$145,779

$114,258

Net market value at death

$1,403,065

$1,437,032

Net savings

 

$33,966

 

For illustration purposes only. The table assumes a marginal tax rate of 40%. For customized results, refer to the Estate Cost Comparison tool.

 

As previously discussed, switching to the segregated fund contract results in realizing a capital gain and prepaying tax but generates a higher ACB of $980,000 (which is the net amount invested). With the mutual fund, $1,000,000 remains invested and the original ACB of $900,000 is used to calculate the income taxes after 10 years of growth. This contributes to a higher final tax bill than with the segregated fund contract. Add to this the probate and estate administration fees, and $33,966 more is left to your beneficiaries by paying the tax on the capital gain now and switching to a segregated fund contract.

Keep in mind that you don’t have to sell your entire portfolio at one time to take advantage of this strategy. You can establish a segregated fund contract or insurance GIC today and move assets into the account gradually. You can choose those assets that trigger the smallest tax consequences and gradually liquidate investments when you and your advisor believe the timing is appropriate.

Beyond the costs

Considering a segregated fund contract often involves looking at more than just the costs as they offer many other potential benefits. A segregated fund contract or insurance GIC can also offer the potential for creditor protection while you’re alive if an irrevocable beneficiary or a beneficiary of the family class is named.5 Where a beneficiary other than your estate is named, your assets will flow outside of your estate and will generally be protected from your estate’s creditors. In addition, the distribution of your assets directly to a named beneficiary is usually done within a couple of weeks after receiving the required documentation, whereas settling an estate can be lengthy, often taking months or even years if the will is challenged. These are just some of the advantages offered by segregated fund contracts and insurance GICs.

Is this the right strategy for you?

To answer this question, Manulife Investment Management created an online calculator that will help you and your advisor determine whether this strategy will work for you. To begin, you’ll need the current value of your portfolio, the adjusted cost base, and your marginal income tax rate. Your advisor can enter these variables in the online calculator and quickly assess if this is the right strategy for your situation.

1 The probate process and fees don’t apply in Quebec. There’s a verification process for non-notarial wills but not for notarial wills. 2 In Saskatchewan, the advantage of preserving a client’s confidentiality doesn’t apply as jointly held property and insurance policies with a named beneficiary are identified on the application for probate despite the fact that these assets don’t flow through the estate and aren’t subject to probate fees. 3 For illustration purposes only. Actual tax rate may vary. 4 This illustration assumes probate fees for Ontario. Your applicable tax rate and probate fees may be different. Legal, accounting, and executor fees vary depending on the complexity of the estate and the professionals retained. 5 In provinces other than Quebec, a family class beneficiary is the spouse, common-law partner, child, grandchild, or parent of the annuitant. In Quebec, a family class beneficiary is a married or civil union spouse, descendants, or ascendants of the owner.

The commentary in this publication is for general information only and should not be considered investment or tax advice to any party. Individuals should seek the advice of professionals to ensure that any action taken with respect to this information is appropriate to their specific situation. Any amount that is allocated to a segregated fund is invested at the risk of the contractholder and may increase or decrease in value. The Manufacturers Life Insurance Company is the issuer of Manulife segregated fund contracts and the Manulife Investments Guaranteed Interest Contract (GIC), and is the guarantor of any guarantee provisions therein. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund and segregated fund investments. Please read the Prospectus or Information Folder & Contract before investing. Investment returns are not guaranteed, their values change frequently and past performance may not be repeated. Manulife, Manulife Investment Management, the Stylized M Design, and Manulife Investment Management & Stylized M Design are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates under license.

MK1929E 07/20

Tax, Retirement & Estate Planning Services Team

Tax, Retirement & Estate Planning Services Team

Manulife Investment Management

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