Tax in retirement: When dividend income trumps interest income
If all goes according to plan, my retirement is roughly 13 years, 7 Months and 28 days away (but whose counting?) There is still a fair amount of time to go, and a lot can change – so although not top of my mind, I have recently been giving some thought on how to minimise my tax burden in retirement.
Naturally you want to pay as little tax as possible (if there is anyone out there wanting to maximise their tax in retirement, get in touch!). The first thing I thought I would check out is the tax efficiency of interest income versus dividend income.
In retirement, you are probably going to want some cash flow coming into your account to fund your living expenses. Now there a many ways to achieve this, but perhaps the most obvious are interest payments and dividend payments.
So a good place to start?
First up, some theory. If you consider it boring, you are welcome to just scroll down to the calculator – I won’t be offended 🙂
Below is some background on how tax on interest income and dividend income works at the moment (2018 Tax Year). You can check out the SARS website for the more official version of the below.
Tax on interest income
Mr Taxman is sometimes kinda a nice guy. With regards to any interest income you receive, he gives you the first R23,800 tax-free (assuming here you are below 65 years old, if you are above 65 you get the first R34,500 tax free). So although not a lot, it is better than nothing. Any interest income over and above that amount, and you are taxed at your marginal tax rate (i.e. the interest income is added to your income for the year, and taxed accordingly.)
So a graph of the interest income versus tax paid would stay at 0 for the first R23,800 of interest income and then it turns into a straight line as the interest income increases and you start paying tax at your marginal rate. (Although this is a little simplified, because, as you receive more and more interest income you will get bumped up through the tax brackets and pay a higher and higher tax rate. So it’s not quite a straight line, more like a series of straight lines, each with increasing gradients. Kapish?)
Tax on dividend income
This works a little differently. Any dividends you receive (note that I am excluding dividends from REITs as they are taxed differently) are taxed at a flat rate of 20% (used to be 15% but was increased for the 2017/2018 tax year (booooo!)). Also, no exemption here – you pay tax from the first cent of dividend you receive (although it would be very interesting to try pay SARS 0.2c :-P)
A graph of this is pretty simple – just a straight line (remember y=mx+c? (*hides under desk*)). Dividend tax is a pretty straightforward calculation independent of your marginal rate.
So at the lower end, from a tax point of view, it is obviously better to earn interest income because there is an exemption before you will need to pay any tax. But as your interest income increases, then you will need to start paying tax. The question now becomes, at what point is it better to receive dividend income compared to interest income?
So I first tackled this problem by looking at an equal lumpsum invested in an account that pays 5% interest compared to investing it in a portfolio of stocks (or single stock for those that like to live on the edge) that has a 4% dividend yield, and a 5% dividend yield.
I then plotted a graph showing what you would end up with after paying tax for varying lumpsum amounts. Obviously the higher up the line on the chart, the better (more after-tax income), and any crossing points represents the lumpsum at which it starts becoming better to receive dividend income compared to interest income (or vice versa).
I used different marginal rates for the interest income. The result is shown below and looks very much like the start of a game of pick up sticks (who remembers that? Fun!). Basically a huge unreadable bit of a mess with crossing points very difficult to make out (click for larger version):
Well, pretty impossible to make any sense out of without the use of some very creative zooming, 20/20 eyesight and a lot of swearing – and then I still wanted to put in how different interest rates would affect the outcome (because let’s be honest 5% is not that great an interest rate). But can you imagine the mess then? And if I added in some extra dividend yield options, we would be looking at a real plate of spaghetti!
The other problem with the chart was that as more interest was earned it would push you into higher tax brackets (as I mentioned earlier). So some interest would be charged at a certain tax rate, and additional interest would be charged at a higher tax rate. In other words my straight line representation of after tax interest income is not entirely accurate.
I wanted something that I could enter any interest rate I liked, any dividend yield I liked, and then any taxable income (which could be used to figure out the marginal tax rate to apply to the interest income). Then, based on these inputs, it should spit out a pretty picture of the after tax amount for interest income and dividend income according to the lumpsum invested. Nice and flexible, and caters for any scenario.
While scratching around for a solution, I stumbled across the the Google Charts API which turned out to be a lot of fun to play with – dare I say more fun than a game of pick up sticks? And the result is much cleaner, clearer and customisable!
Tax calculator – interest vs dividends
Before you dive right in, a disclaimer – this calculator thingy is just a guide, and if you have a complicated tax situation you should probably consult a financial adviser or tax adviser – so use it at your own risk.
Also, this is based on the 2018 tax year, and it is for someone under 65 years of age (there are additional tax breaks if you are above 65, and even more if you are above 75). I hope that future me remembers to keep this updated. If someone from the future reaches this page and I have not updated it, please let me know. (Or go back in time, pick me up, take me forward in time, then I will update it quick, and then you can bring me back to the present.)
Ok, so a quick run down on how to use the calculator:
- Enter your annual taxable income. If you are still working, this could be your salary. If you are retired, you may be getting taxable income from an annuity or taxable income from a rental property. This amount will determine your marginal tax rate for the calculation of the amount of tax on the interest income. If you want to ignore any other taxable income, then just make the value 0.
- Enter an interest rate. I guess the current going rate for a Money Market is around 7% these days? RSA retail bonds maybe give a bit more than that.
- Enter a dividend yield. The value you use here could vary greatly. In general you will do well to find a share with anything more than a 5% dividend yield – but not impossible. And of course dividends generally increase over time. So the yield on what you originally paid for a dividend-yielding investment should increase with each passing year and over many years could well end up in double digits (but the lumpsum would probably increase too and could at any time be transferred into an interest-bearing account (less brokerage fees)).
- The graph will show you two lines representing the total after-tax income based on the lumpsum invested in either an interest-bearing account (blue line) or a dividend-yielding stock/portfolio/ETF (red line). Since you want to maximise your after-tax income, the higher up the line the more tax efficient it is for the given lumpsum on the x-axis.
- If you want to examine crossing points more closely, you can zoom in using the slider on the bottom of the chart. You can also hover over a certain point to get the lumpsum value and after tax income at that point.
Firstly, and I think this is very important: Tax should never be the starting point when deciding what to invest in. That is like the tail wagging the dog, or putting the horse before the cart, or *insert animal idiom of choice here*
Cash and dividend paying stocks/ETFs are very, very different asset classes. First decide on your investment goal, risk tolerance and duration, and base your investment choice on that. Then try minimise tax.
Cash (which pays interest) has different characteristics to an investment in dividend paying shares/ETFs. So for example, don’t choose cash as an asset class for a very long-term investment just because you will pay less tax on the interest.
Other things to mention
- If you can get a good interest rate on your cash (say 7%) then you are going to struggle to find stocks that have a high enough dividend yield to be more tax efficient. (For example, no matter the lumpsum, a dividend yield of 5% will never result in more income than an interest rate of 7%, no matter what tax bracket you are in.)
- At higher taxable incomes and with equal interest rates and dividend yields, dividends will be more tax efficient due to the lower tax rate (20%) applied to them compared to the high marginal tax rate applied to interest (up to 45%).
- Of course you could split a lumpsum and, for example, invest some in an interest-bearing account while it is more tax efficient to do so (until the lines in the above chart cross) and then put the rest in a dividend paying investment.
- I think having a portion of your retirement funds in cash is probably a good idea for anyone, regardless of their tax scenario (emergency fund/flexibility when markets are down etc.) As an added bonus you can score some tax-free interest on this. Bear in mind that at a 6% interest rate, you can have around R400,000 in cash and not have to worry about paying any tax on the interest.
This article is republished with the kind permission of Stealthy Wealth, a blog site run by an embedded software engineer with degrees in electronic engineering and IT, who is on a mission to retire by the age of 45.
Disclaimer: The information above is not intended to be and does not constitute financial advice, investment advice, trading advice or any other advice or recommendation of any sort offered or endorsed by HomeTimes and Stealthy Wealth. Any expression of opinion is personal to the author and the author makes no guarantee of any sort regarding accuracy or completeness of any information or analysis supplied.