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In a scenario where, for example:

An employee exercised a "same-day-buy-and-sell" operation on his employee stock options. He ends up making a profit / gain of $10K. He already has a yearly salary of $55K. Because of this Capital Gain, the employee worries about how much he/she will get taxed and whether or not he will be bumped into a higher tax-bracket.

Just to get some clarity on tax-brackets first:

  1. Is it true that only 50% of the Capital Gain is subject to taxes? (ex: %50 of $10K = $5K)
  2. How much of that 50% is actually taxed? Does that depend on your current tax-bracket based on just your salary? Or is it ($Salary + 50% of Capital Gain?) = $Amount used to determine which bracket you stand in?

Now, would transferring the Capital Gain (immediately once received) to a TFSA work in the employee's favor in order to cut down on taxes?

  • Is it correct to assume that - since a limit of $5K can be stored in a TFSA, the remaining amount (ex: $10K - $5K in TFSA = $5K remaining) would then be subject to the same calculations the full Capital Gain would have undergo? (so %50 of $5K = $2.5K)
  • Does the amount tossed in the TFSA have to stay for a certain period of time (days, weeks, months?) before it can be transferred over a standard bank account and/or used to purchase expensive items?

Overall, would there be better alternatives to reduce your tax payout other than reinvesting into more stocks, or mutual funds? How about education? First-time home buyer / mortgage?

Sorry for the immense question, but this knowledge territory is really blurry for me. Any external resources would be appreciated as well.

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1 Answer

In response to your points #1 and #2:

  • In general, yes it is true that capital gains are only subject to half one's marginal rate of income tax. That doesn't mean 50% of the gain is due as tax... rather, it means that if one's marginal tax rate (tax bracket) on the next $10K would have been, say, 32%, then one is taxed on the gain at 16%. (The percentages are examples, not factual.)

    However, because these are employee stock options, the tax treatment is different than for a capital gain!   Details:

    On the Federal tax return are lines for reporting Security option benefits (Line 101) and Security options deductions (Line 249). The distinction between a regular capital gain and an employee stock option benefits is important. In many cases the net effect may be the same as a capital gain, but the income is characterized differently and there are cases where it matters. Somebody who is about to or has realized employee stock option benefits should seek professional tax advice.

In response to your next two points:

  • No, one cannot transfer a capital gain or other investment income into a TFSA immediately after-the-fact in order to receive the tax-free benefits of the TFSA on that income. Only income and gains earned within a TFSA are free from tax – i.e. The options would have to have been in the TFSA before being exercised. Once a gain or other investment income has been realized in a non-sheltered account, it is considered taxable. The horse has already left the barn, so to speak!

  • However, despite the above, there is another strategy available: One can create an offsetting deduction by contributing some of the realized gain into an RRSP. The RRSP contribution, assuming room is available, would yield a tax deduction to offset some tax due on the gain. However, the RRSP only defers income tax; upon withdrawal of funds, ordinary income tax is due (hopefully, at a lower marginal rate in retirement.)

  • There is no minimum amount of time that money or assets have to be inside a TFSA to benefit from the tax-free nature of the account. However, there are limits on how much money you can move into a TFSA in any given year, and many folks weren't aware of the rules.

p.s. Let me add once more that this is a case where I suggest seeking professional tax advice.

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You sir, are a godsend! Thank you very much for this valuable information and I will more than likely seek professional tax advice. Still, I can't thank you enough for answering this AND putting it in an easy-to-grasp fashion, I especially like the "horse has already left the barn" metaphor :D –  bigp Jun 24 '11 at 14:36
    
@bigp You're welcome. I'm happy to have helped. –  Chris W. Rea Jun 24 '11 at 15:32
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