There has been a lot of talk about how lenient capital gains tax in South Africa is. Stealthy Wealth wrote a good article about this, called I love capital gains tax. If you must pay tax, pay capital gains tax. There exists an option to reduce the tax payable on your equity investments even further by using the capital gains exclusion. This is also called tax harvesting.
This can be viewed by the South African Revenue Service (SARS) as tax avoidance. So the purpose of selling your Exchange Traded Funds (ETFs) should always be to re-balance your portfolio. To explain how this works, let’s firstly look at the capital gains tax law.
Capital gains tax
If your strategy is to retire with equities, like I plan to retire, this will be the type of tax you pay. Your growth will be taxed as capital gains, while your dividends will trigger dividend withholding tax (or phantom distribution in total return ETFs). This will not apply to money saved in your Tax-Free Savings Account (TFSA), only the taxes ETFs you own. Which according to my calculations should eventually make up about 60% of my portfolio.
To calculate your capital gains tax, you first need to determine what portion of the capital you contributed. This is also known as your base cost. You can keep track of this by simply adding all your contributions together. Alternatively, your broker will also list the base cost. Easy Equities keeps track of this number on your account overview (listed as the purchase value).
Once you have this figure, you subtract this from your total investment value to determine your capital gains. Now express the capital gains as a percentage of the investment value. This should be somewhere in the range of 70% to 80% if you invested for 30 plus years. In other words, you only contributed 20% to 30% of your portfolio value.
When you sell shares to fund your retirement, you will pay tax on your gains. If you need R500 000 per year and your capital gains percentage is 70%, you’ll pay capital gains tax on R350 000.
To calculate the tax you will pay, you firstly subtract your exclusion amount of R40 000, then pay income tax on 40% of the remainder. To apply this to the previous example, we will subtract R40 000 from R350 000 and pay tax on 40% of the remainder, or R124 000. The total tax you will pay is therefor R8 253 (effective tax rate of 1.65%). This is a simple example, but you will need to know this to understand the next part of this discussion.
Snowballing the exclusion
The basic idea with this strategy is to sell a portion of your shares every year in order for your capital gains to be R40 000. You declare the profit to the South African Revenue Service (SARS), but don’t pay tax on it because it is below the exclusion amount. Then you buy another ETF to re-balance your portfolio. Since you are spending the R40 000 in addition to your initial investment, it raises your base cost. This means that when you sell the shares in retirement, your tax is lower.
So how will this influence your portfolio? Firstly, we need to design a hypothetical scenario. Let’s assume we buy shares to the value of R5 000 per month and increase this contribution by 6% every year. For simplicity, I assumed an average investment return of 12% per year.
After 40 years we have saved R82.8 million. This has a spending power of R13.2 million today. The base cost for this investment is only R9.2 million or 11.2% of the investment value. Can we just take a moment to appreciate the absolute wonder that is compound interest? 88.8% of the portfolio value is profit.
Running the numbers
By selling and buying to utilise the R40 000 exclusion every year, you increase the base cost to R11.5 million, or 14% of the investment value. I assumed that the trading costs are 0.25% to sell and another 0.25% to re-buy the shares. This reduces your portfolio value from R82.8 million to R81.9 million. This is R13.05 million in today’s money. Now let’s analyse the numbers based on retirement at 65.
|Invest and hold||Utilise exclusion|
|Income at 4%||R527 279||R521 772|
|Profit||R468 122 (at 88.8%)||R448 752 (at 86%)|
|Taxable income||R171 249||R163 501|
|Tax payable||R9 045||R7 650|
|Monthly income||R43 186||R42 843|
Using the buy and hold strategy your portfolio size is larger, but you pay more tax on the income. However, this strategy still comes out slightly ahead. In the end, it is still better to buy and hold, since the fees to trade are simply too high to make the strategy feasible.
On top of the fact that it is not feasible, there are also a few legal complications with capital gains tax harvesting. Although SARS makes provision for this in the tax law, it can still be viewed as tax avoidance. Our tax law also states that you must hold shares for 3 years for the profit to be capital gains. So you would only be able to sell a third of your shares per year or sell every third year.
To be honest, I’m glad the buy and hold strategy is better than capital gains tax harvesting. Having to declare the profit every year sounds like a lot of unnecessary effort and I’m way too lazy. Capital gains tax harvesting simply is not worth the effort. Once again doing nothing makes you a better investor. Ultimately, there is no better investment strategy than simply increasing your savings rate.
Be safe out there,
Quote of the week“All I ask is the chance to prove that money can’t make me happy.” – Spike Milligan. Click To Tweet
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