In­vest DIY: A tax-savvy way to use your port­fo­lio in re­tire­ment

If you are look­ing to gen­er­ate in­vest­ment in­come in re­tire­ment, high-yield­ing div­i­dends are an ob­vi­ous choice. But it may not al­ways be the best one.

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for most of our in­vest­ing life, we are fo­cused on cap­i­tal growth. We want our in­vest­ment to grow and get big­ger at a pace faster than inflation (af­ter fees) so that we are creat­ing real wealth for us to live off in re­tire­ment. Then, when we hit re­tire­ment, the fo­cus shifts to earn­ing an in­come from those in­vest­ments.

A re­tire­ment an­nu­ity (RA) or pen­sion scheme will be used to buy an an­nu­ity that will gen­er­ate in­come, but what of our own do-ity­our­self (DIY) port­fo­lio?

If you are a DIY in­vestor, you will likely want to con­tinue to man­age your own port­fo­lio, but with a shift in pur­pose to re­ceiv­ing in­come. As a rule, you then tend to fo­cus on div­i­dends, search­ing for those high-yield­ing stocks. The ob­vi­ous choice is prop­erty, which typ­i­cally has the high­est yield of any sec­tor in the mar­ket. Pref­er­ence shares also look good, but of­fer no cap­i­tal growth, which means your in­come never grows. You can also fo­cus on in­di­vid­ual high-div­i­dendyield­ing stocks, but this fo­cus on div­i­dends has some prob­lems.

Firstly, there is the risk of a div­i­dend dis­ap­pear­ing. For ex­am­ple, Kumba and As­tral Foods were two stocks with very high div­i­dend yields, but div­i­dends dis­ap­peared as the re­spec­tive stocks went through tough times. Both have re­turned to great div­i­dends, but there were a few years when no div­i­dends were paid.

If you are buy­ing high div­i­dend yields, the ques­tion is how sta­ble are they likely to be? The re­al­ity is that high div­i­dends of­ten come from very cycli­cal stocks that are ei­ther boom­ing or bust­ing. When boom­ing, they pay out like crazy. But when the lean times ar­rive again, the pay­outs stop.

An in­vestor fo­cus­ing on in­come should then per­haps be pre­pared to ac­cept lower yields that are more sta­ble. This could be found with ma­ture stocks that have lower growth prospects but that are pay­ing a de­cent and, im­por­tantly, re­li­able div­i­dend.

The other big is­sue is tax; the div­i­dend with­hold­ing tax rate in South Africa is 20% and that is fairly chunky. Prop­erty stock dis­tri­bu­tions are added to your in­come so, de­pend­ing on your over­all in­come, it might re­sult in that in­come be­ing taxed at an even higher tax rate.

Tax-free ac­counts solve this prob­lem by be­ing to­tally tax free – but they also have lim­its of R500 000 over a life­time and that may sim­ply not be able to gen­er­ate enough in­come for a per­son to live off in re­tire­ment.

The other op­tion is to con­tinue to fo­cus on growth rather than in­come and sell­ing down some of those stocks ev­ery year for liv­ing ex­penses. You would still pay tax, but it would be cap­i­tal gains tax (CGT) of which, cur­rently, the first R40 000 per an­num is tax free. Then, 40% of any re­alised cap­i­tal gain above the thresh­old will be added to your tax­able in­come.

So, even if you are in the top tax bracket of 45%, your CGT would max out at 18% and po­ten­tially be closer to an ef­fec­tive 10% once the R40 000 ex­clu­sion and slid­ing tax rates are taken into ac­count. Ef­fec­tively, you’ve halved your tax li­a­bil­ity.

The trick is then to have a de­cent pile of cash to live off, so you are not forced to be a seller of shares for liv­ing ex­penses when mar­kets are un­der pres­sure. In an ideal world, a year or two of liv­ing ex­penses in cash means you can draw down on the cash when mar­kets are tum­bling and sell off shares as they are soar­ing.

There are, of course, a lot more mov­ing parts when con­sid­er­ing re­tire­ment in­vest­ments and tax, but the usual rule of buy­ing high div­i­dend yields may not al­ways be the best one. ■ ed­i­to­[email protected]­

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