February marks a crucial time for South African financial planners and their clients, as proactive strategies can significantly impact tax savings and long-term wealth accumulation. As the Tax year end approaches, South African financial planners and their clients face a pivotal opportunity to strategize tax savings ahead of year-end. While these strategies are well-known, it's crucial to also consider the often-overlooked annual R40,000 Capital Gains Tax (CGT) exemption, an effective means to realize profits without additional tax burdens.

The Tax Benefits of TFSAs and Regulation 28 Investments

Before diving into CGT, let’s revisit the tax advantages of TFSAs and Regulation 28 investments, which are particularly relevant in February as the tax year-end looms.

Tax-Free Savings Accounts (TFSAs): Contributions to TFSAs are made with after-tax income, but all growth, dividends, interest, and withdrawals remain tax-free. This makes TFSAs an excellent tool for long-term wealth accumulation. The annual contribution limit is R36,000, with a lifetime cap of R500,000.

Regulation 28 Investments: These are retirement-focused investments that comply with Regulation 28 of the Pension Funds Act. Contributions to retirement annuities (RAs), pension funds, and provident funds are tax-deductible up to certain limits, and the growth, dividends and interest within these funds is tax-free. While withdrawals are taxed, the tax-deferred growth makes these vehicles highly effective for retirement planning.

While maximizing contributions to TFSAs and Regulation 28 investments is essential, it’s important not to overlook a valuable tax lever: the annual Capital Gains Tax (CGT) exemption of R40,000 per individual.

The CGT Opportunity: Growth and Tax Gain Harvesting

Discussing CGT with clients can be challenging, as most investors prefer to minimize taxes, particularly in an environment where trust in government spending is low. As a result, many clients and advisors avoid realizing capital gains altogether. However, this tax aversion can lead to suboptimal investment decisions. Paying CGT isn’t necessarily negative—it signifies portfolio growth.

As financial advisors, we can guide our clients in several key areas:

• Avoiding Tax-Driven Decisions: Investors may hold onto underperforming assets simply to avoid CGT. However, tax implications should never be the sole driver of investment decisions. The primary focus should always be on achieving optimal returns and aligning investments with clients' long-term objectives.
• Timing is Key: By strategically realizing gains of up to R40,000 each year investors can minimize their tax burden while repositioning their portfolios in alignment with their financial goals.
• Strategic Tax Gain Harvesting: When a portfolio adjustment is necessary, tax Gain harvesting becomes a valuable tool. This involves analyzing the client’s portfolio to identify capital gains that can be realized within the R40,000 exemption limit, ensuring tax efficiency while optimizing investments. Refer to the practical example below.

Portfolio Analysis and Implementation

To effectively implement a CGT strategy, a detailed analysis of the client’s investment portfolio is essential. The goal is to pinpoint assets where realizing a R40,000 capital gain would free up the most capital for reinvestment in a more suitable strategy.

Tax Gain Harvesting Practical Examples:

Example 1: Your client (age 35 with a 30% marginal tax rate) had a discretionary investment on 1 March 2015 worth R 2,000,000 with a base cost of R 700,000. Assuming the investment grows annually by 10% (80% capital growth, 10% dividends, 10% interest), with all net dividends and interest reinvested, the portfolio will be worth R 32,954,291 at retirement. However, this would trigger a CGT liability of R 3,159,413, leaving the client with a net amount of R 29,794,878.

If you had advised the client to max out their TFSA contribution by realizing and moving funds from the discretionary investment to be invested immediately into the TFSA with the same growth, the overall portfolio at age 65 would be R 33,163,771 with a CGT liability of only R 2,761,002, leaving the client with a net amount of R 30,766,459 - a saving of R 971581.

Example 2: Furthermore, if the client did not contribute to a Retirement Annuity (RA), you could have liquidated enough funds each year to top up the RA to the maximum (R275,000) without triggering a CGT liability. This would result in a portfolio of R 33,204,771 at age 65 with a CGT liability of only R 2,438,313 leaving the client with a net amount of R 31,076,376- a saving of R 1,281,498.

Example 3: Your client is approaching retirement with an inappropriate aggressive investment strategy. Rather than waiting until retirement age to make changes and trigger a large CGT liability, you can start making adjustments 5 years before retirement by using the R 40,000 annual CGT exemption.

Assuming the client has a R 2,000,000 investment on 1 March 2025 with a base cost of R 700,000, making no changes would result in a CGT liability of R 243,054 at retirement. However, by strategically switching the maximum possible amount year 1 to 4 without triggering a CGT liability, you can bring the CGT liability in year 5 at retirement down to R132,000

These examples illustrate the significant impact that strategic and active tax planning can have on a client's long-term portfolio and wealth accumulation.

Key Considerations:

• Investment Goals and Objectives: Ensure any tax gain harvesting strategy aligns with the client’s long-term financial goals, objectives, and risk profile before making changes.
• Professional Advice: Navigating CGT complexities requires professional financial guidance to tailor a strategy that best suits the client’s circumstances.

In conclusion, while TFSAs and Regulation 28 investments are powerful tax-saving tools, incorporating strategic CGT harvesting can further enhance tax efficiency and portfolio performance. By proactively managing CGT liabilities and taking advantage of the annual exemption, investors can optimize their portfolios and potentially achieve better long-term outcomes. As financial advisors, we have a critical role in ensuring that we continuously make strategic investment decisions for our clients future. Tax gain harvesting should be used as a strategy to optimize tax liabilities, not to evade them. While tax optimization is a lawful practice, tax avoidance through improper means is against the law.

Written By: Ingrid Breed