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Tuesday 29 May 2018

I Love Capital Gains Tax

Said no one...ever!
If all goes according to plan, I will be financially free in around 12 years from now.

The idea is that, at this point, I will be able to cover my living expenses by drawing an income from my investments.

This income could come from a number of sources including (but possibly not limited to):

  • Dividends from the ETF’s I hold
  • The living and/or life annuties I will be forced to buy when I access my pension fund
  • Selling off a portion of the capital value of the investments in my portfolio
  • Rental income from my investment property (if I still have it by then…)

I will be using the 4% Rule to guide me in the amount I draw each year, and this means I am not too concerned with exactly how my annual income is generated – a rand of dividend income is the same as a rand generated by selling ETF’s which is the same as a rand taken from a living annuity.

However, SARS takes a very different view on this – depending on where the income comes from will have an impact how much Tax I will have to pay. Income is taxed differently according to how it was generated. Depending in which tax category the income falls will determine the tax rate payable on that income.

Different Tax For Different Incomes

In a very-far-from-comprehensive nutshell, the table below shows how various types of retirement income is categorised and taxed (Please note that this is far from conclusive – for example I am not considering interest income that could be generated from Bonds and Cash (which could well make up some part of a retirees income))

Just quickly – some assumptions/disclaimers for the rest of this article.

  1. Since I will be younger than 65 when I start drawing an income from my investments, I will qualify for a rebate of R14 067 per annum.
  2. Income tax and dividends withholding tax are both relatively straight forward calculations, and will be the same for everyone. However Capital Gains Tax is a bit of a special child. The value of your Capital Gain depends on your base cost – or how much you originally paid for the investment. So this can differ significantly from person to person. For the remainder of this article, I will assume that the base cost is a pretty much impossible R0, and the entire value of any sale is a Capital Gain. This simplifies things a lot, and also provides a worst case scenario.
Right, let’s get to the juicy bits…

Income Tax vs Capital Gains Tax vs Dividends Withholding Tax

The chart below (click for larger image) shows the tax payable according to how much income is taken, and the type of tax applicable.

Or, to put it another way, this next chart shows the % tax payable for different type of incomes:

As you can see, the way in which retirement income is derived, can have a massive impact on the amount of tax payable. Depending on your income needs, there are better and worse ways to generate income.

If you are going to choose only one way of deriving income in retirement, the most tax efficient way to do it is via Capital Gains. If all your income is from Capital Gains, you only start paying Tax on amounts more than R220,000 per annum, and from there, the rate rises very gently to only 7.4% if you draw an income of R1,000,000 per annum (sheesh high roller!)

Second prize is a little more tricky, because now it depends on the amount of annual income. On smaller amounts, dividends are less tax efficient than income from an RA or rental property. But from around R400,000 per annum, it flips around and it starts becoming more tax efficient to derive your income from dividends.

The two graphs above also illustrate why I dislike RA’s (especially if you already have a pension fund) because the annuity product you are forced to buy, generates income which is taxed at less favourable Income Tax rates. Someone younger than 55 will start paying Tax from around R80,000 of annual income. Someone drawing R1,000,000 a year will pay a whopping 31% in Tax (compared to 20% if income is received via dividends and only 7.4% if income is generated through capital gains.)

The above graphs are nice and general, and covers a wide range of income requirements. But what I am interested in is where on the curves I expect to find myself, and how that will affect my Tax situation?

How This Affects Retirement Income

Right let me get out the trusty crystal ball…

According to my projections, my family would need an income of roughly 320,000 of 2018 Randela’s per annum to cover our expenses. (This will become less once Stealthy Junior gets booted from the nest at 18 my son decides its time to get his own place.)

The chart below (click for larger image) is the same Tax Rate chart from previous, but I have marked the R320k per annum data point on each of the curves.

Hey SARS... Nice curves!
Well would you look at that! If I could generate all my retirement income via CGT, it would give me an extremely palatable 1.9% tax rate. I am certainly not going to complain about that! And when you consider that this Capital Gain calculation ignores the deductible base cost, it basically means if all income were generated through Capital Gains, I would pay 0 Tax and everything would fall straight into my wallet.

The DWT and Income Tax rates are considerably more ugly.

If I were to generate my income requirement through Dividends, SARS would gleefully lay claim to a fifth of that, and I would end up with only R256 000 a year after Tax. To put it another way, I would have to generate R400,000 in dividend income to end up with my required R320,000. That means my income requirement (and associated amount needed before I could retire) would be 25% more. Yuck.

If I were to generate all my income through a Living/Life Annuity and/or Rental properties and/or REIT investments, I would pay 16.93%. Also not pretty. That would again mean I would need a significantly larger lumpsum, to cover the increased drawdown of about R385k (to give me an after Tax amount of R320k). Now you can see why I do not lik RA's - they force you to convert a minimum of 2/3’s of an RA to an annuity product on retirement – and if this is all you have you will be forced into income tax for the rest of your life, with no tax flexibility.

In Practice

Okay, so that was all pretty theoretical – but the conclusion seems obvious. In theory, I need to try generate as much of my retirement income through Capital Gains. But in practice, this will be impossible because:
  • I have a pension fund, which means I am going to have to buy an income generating annuity, and so some of my retirement income will fall into the Income Tax category
  • A lot of investment products pay dividends, and will be liable for dividends withholding tax. 
But (there always seems to be a but!) not all hope is lost:
  • If I can structure my annuity income to be less than around R80k per year, then I will pay 0 income tax. Got to love the tax rebate!
  • Both my wife and I have a TFSA – anything in there is Tax Free. This seems like a good place to park the higher taxable stuff like dividend generating investments and property REITs (if the annuity income is already bumping up against the maximum tax free amount)
I may not get away with paying 0 tax, but I think I will be able to get pretty close (hopefully!)

The Future Of Tax

Well this was a useful exercise, and it certainly got me thinking. But it is not something I am paying too much attention to right now. While this gave me a good idea of the lay of the tax land, there is so much that can change from now until my estimated retirement date. 12.5 years is a long time, and in-between now and then, there could be a host of new products, which could be subject to all kinds of new tax laws and exemptions. And then of course the income brackets, CGT rates and DWT can (and will) be revised.

I think the best takeaway is to make sure you have some tax flexibility in retirement. You have heard how you should have geographical and asset diversification in your retirement investments. I would recommend building some Tax diversification as well. Personally I am investing in some Reg 28 products, TFSA’s and discretionary investments. That way I will hopefully ensure I can get as close to 0 tax as possible in retirement.

Till next time, Stay Stealthy!
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