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Why high dividends can be taxing

Dividends are the best. “Free” cash arrives in your account and you get to spend it any way you want.
   
But they are also a drag, as they’re taxed at 20% dividend withholding tax (DWT), whereas the highest possible capital gains tax (CGT) at the top income bracket is 18% (40% inclusion rate at the 45% tax bracket for those earning over R1.5m annually).   

With CGT, admittedly, the first R40 000 every year is CGT free, which tilts the equation back to dividends – unless you’re receiving a truckload every year.  

This tax liability suddenly makes the good old-fashioned dividend less exciting. 

So why do investors love dividends so much, aside from the email notification that money has arrived in their brokerage account?  

There is another aspect to dividends that is often ignored. A return from owning a stock is made up of two parts. 

First, there is the capital gain in that the price moves higher, and then there is the dividend received. 

Investors will excitedly talk about a stock that pays high dividends, ignoring the fact that these sorts of stocks are typically very mature companies that therefore have lower growth prospects, which means lower capital growth prospects too. 

So, when adding the two parts of the return together, you often end up at around the same average return.  

What this means is you need to consider why you may want dividends, and if they’re actually suited to your plan. As a rule, dividends are really for when you’re living off a portfolio, where the cash flow from dividends goes towards your living expenses.   

But, with the above tax implications, you could just as efficiently be selling down shares you own to generate the cash flow required. Consider a R1m portfolio paying a 10% dividend yield, which nets R100 000 per year in dividends. After tax, it is R80 000. 

However, you could just as easily sell down R100 000 of stock to net the cash flow, incurring transaction costs of maybe 1% and a tax liability of only 18% on R60 000. (Because, remember, the first R40 000 is CGT-free.) 

This results in a net cash flow of R89 200 before costs.

Now two things are important in the above example. First, if it is a R10m portfolio instead of R1m, you still only get the first R40?000 of CGT tax-free, so the numbers change. 

Second, it is important that the non-dividend-focused portfolio is growing at a faster rate than the dividend portfolio. This faster growth needs to compensate for the extra dividend as well the growth.  

If the 10% dividend-yielding portfolio grows at an average 5% per year, this offers 15% growth per year, and the non-dividend portfolio would need to be doing at least the same growth.  

There is one trick here worth considering. A tax-free account is, as the name suggests, totally tax free. This means there is no DWT, and it is therefore the best vehicle for your high-dividend-paying ETFs in order to generate simple cash flow.   

The saving is small, depending on your CGT liability, but a number of people have put their high-dividend property ETFs into tax-free accounts. 

The issue here is the limits of how much you can invest in a tax-free account, and this number is currently capped at R33 000 per year.  

At the end of the day, while I love dividends, that love has more to do with the emails from my broker and the cash entry into my account than the actual dividends.  

A portfolio with a very low dividend yield could well be a better alternative than a high-dividend-yielding portfolio. Even if you are living off it.

This article originally appeared in the 21 June edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.

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