Ninety One tax warning to South African investors

The impact of capital gains tax on investment returns is often overlooked, and investors looking to rebalance their portfolios should be aware of the associated costs.

This is according to Ninety One sales manager Paul Hutchinson, who said investors are often encouraged to remain invested long-term, even during periods of instability and volatility.

However, he said there are several warning signals that should trigger the re-evaluation of an investment’s portfolio.

For discretionary investors, even if a warning signal triggers a re-evaluation of their investment, they must consider the early payment of capital gains tax when making portfolio changes.

Capital gains tax is not a separate tax but forms part of income tax. It arises when an investor disposes of an asset for proceeds that exceed its base cost.

Hutchinson said that, while often considered, the impact of capital gains is seldom quantified. 

“This is an important exercise because when an investor disinvests intra-term and pays capital gains tax, there is the compounding opportunity cost of the tax paid,” he explained.

Simply put, an investor in the maximum marginal tax bracket who realises a capital gain of  R100,000 pays capital gains tax of R18,000 if he has already used his annual capital gains exclusion of R40,000.

Therefore, the opportunity cost to the investor is the difference between the future growth on the full R100,000 – if he did not realise the investment – versus the growth on only R82,000. 

“This opportunity cost is often missed in the investment planning process because the capital gains tax on a portfolio rebalance is generally paid later in the year and often from an investor’s other liquid assets,” Hutchinson said.

He said investors should also consider the impact of capital gains tax if they switch out of fund A and into fund B at some point during their investment term.

In this case, fund B may require an additional return to compensate the investor for the early payment of capital gains tax. However, Hutchinson said this is dependent on multiple factors. 

These include the return profiles of fund A and fund B, the investor’s investment time horizon, and at what point in the horizon the investor decides to switch.

As an example, he compared the experience of two investors – Jack and Jill – who invest a similar amount in fund A at the same time and have an investment time horizon of ten years.

Fund A delivers a consistent return of 10% per year, and Jack remains invested for the full ten years, at which time he disinvests and pays his capital gains tax liability. 

Jill identifies a warning signal and decides to switch out of fund A after five years. After paying her capital gains tax, Jill invests the remainder of her proceeds into fund B. 

The table below sets out the excess return per annum that fund B must deliver over the following five years so that Jill has the same fund value as Jack at the end of the ten-year term.

Therefore, for an annual return of 10% per year, fund B must produce an additional 0.60% so that Jack and Jill finish on the same fund value after ten years. 

Hutchinson said this difference represents the opportunity cost of paying capital gains tax after five years.

Ninety One’s analysis shows that –

• The required additional return from fund B increases as the return from fund A increases.
• The longer the investment time horizon, the greater the additional return required from fund B.
• The earlier into the investment term horizon an investor switches, the lower the additional return required from fund B and vice versa.

Hutchinson said the impact of capital gains tax on making changes to an investment portfolio should be carefully considered and quantified. 

This impact can set a portfolio back and should, therefore, be evaluated against the expected benefit of the portfolio change. 

“Given the multiple factors that will affect this decision, we strongly recommend that you consult with a qualified financial advisor and seek expert tax advice, as required,” he said.