When managing your discretionary investment portfolio, one crucial aspect often overlooked is the impact of unrealised capital gains. This is the profit built up in your investments that have not yet been sold (realised) and therefore, not yet taxed. Many investors understandably hesitate to realise these gains, often citing tax deferral as an advantage. However, from a proactive financial planning standpoint, there are some compelling reasons to rethink this approach, particularly as tax rules evolve.
Understanding Unrealised Capital Gains
Unrealised capital gains are the increases in value of your assets, such as shares or unit trusts that remain unsold. These gains exist on paper, but have not been subject to tax because, you have not sold the underlying investment. You have not ‘realised’ the gain.
Tax Harvesting: Realising Gains to Your Advantage
Tax harvesting is the active strategy of realising capital gains each year, even if you do not immediately need the proceeds. This deliberate approach can offer significant long-term benefits:
- Annual capital gains exclusion: Each South African taxpayer enjoys an annual exclusion of R40,000 before any capital gains tax (CGT) is due. By selling enough assets each year to use this exclusion, you can realise gains tax-free.
- Raising your base cost: When you realise a gain and repurchase the asset, the base cost for future CGT calculations increases. Over time, this means less cumulative capital gain is subject to higher inclusion rates.
- Smoothing the tax burden: Rather than facing a significant tax bill if you need to liquidate a larger portfolio in the future, strategic annual realisations allow you to spread the tax liabilities over multiple years.
It is never nice to pay tax, but it may make sense to do so over a few tax years instead of a once off, as this can effectively reduce the overall tax liability.
Beware: Inclusion Rates Are Likely to Increase
Currently, only a portion (the “inclusion rate”) of your capital gain is included in your taxable income and taxed at your marginal rate. Currently the inclusion rate for individuals is 40%. Over the years, the inclusion rate for individuals in South Africa has increased and is widely expected to continue rising. If you defer realising gains for many years, you may end up paying a larger share to SARS in the long run.
Myths & Misconceptions
- “Deferring tax is always best”
Not if rates are likely to rise or if you risk being pushed into a higher tax bracket in future. - “It is risky to realise gains regularly.”
With careful planning and using your allowable annual exclusion, the risk is limited and the potential reward is lower overall tax, which can be significant.
Do not Be Afraid to Unlock Gains and Raise Your Base Cost
Embracing tax harvesting gives your portfolio more resilience against future tax changes. By regularly realising gains and resetting your base cost, you benefit from lower future exposure to potentially higher CGT inclusion rates and may have more flexibility to manage your wealth when opportunities or needs arise.
Do not let a tax decision cloud a sound investment decision
Often you find that an investor has a historical large holding in one share, for example, one that has done incredibly well over time. It may now be the right time to sell and diversify however, the tax bill discourages the investor from acting. Even though it is a good investment decision to sell and diversify, the investor holds out sometimes with dire consequences or with an even higher tax bill to pay in the future.
Do not let the fear of triggering a tax bill discourage you from optimising your discretionary investments. Structured and intentional realisation of capital gains is a sound financial planning tool. Speak to your financial advisor to implement a tax harvesting strategy that aligns with your goals and circumstances.
0 Comments