After Tax Cash Flow

Maximise your Retirement Income when Interest Rates are High

Changes in interest rates can adversely affect your after tax cash flow in differing ways depending on your circumstances.

Interest rate increases may make it necessary for you to review your financial plan as increased interest rates may provide a windfall for you as an investor or retiree with capital if you are able to take advantage of opportunities. Skilful financial planners can unlock meaningful increases to your cash flow.

Generally, increased interest rates favour investors (most often pensioners) who have money market and cash investments, as they will now be receiving a higher return on their capital.

The flip side is that an increased return on your investment may push you above the tax-free interest exemption, thus reducing your after tax cash flow. The interest exemption for individuals under the age of 65 is R19 000, and for individuals above 65 is R27 500.

So a retired, married couple can receive a tax-free, near risk-free return (depending on the bank or institution) of R55 000 a year. Assuming you and your spouse receive an interest rate of 11% and are older than 65, each could be holding up to R250 000 in interest-bearing investments. When doing this calculation you need to consider your unit trust investments as well as most investment funds have some exposure to interest-bearing investments.

For example, the average balanced fund may have about 15% exposure to interest-bearing assets. So if a balanced unit trust investment is worth R100 000, R15 000 will be interest bearing.

Once again assuming an interest rate of 11%, this unit trust investment will be earning you about R 1 650 of interest which must be considered when calculating your gross interest earnings.

This does not apply to investments housed in retirement funds like provident or pension funds or retirement annuities. It also does not apply to endowments as the tax is paid by the institution and not by you as the individual.

Higher Interest Rate = Higher Return = Lower After Tax Cash Flow?

Increased interest rates mean your interest-bearing assets are producing a higher return. It may mean more tax, which in turn may lead to a decrease in after tax cash flow. A way to counter this is to ensure your cash exposure in excess of the interest rate exemption is predominantly held in retirement fund assets. Tax on retirement funds has been abolished, so any interest earned within a retirement fund is tax free.

A Quick Example - Higher After Tax Cash Flow

In the accompanying example, we assumed a married couple over the age of 65 who require a real return of 4%.

They are invested in a balanced strategy with half the investments in a unit trust and the other half in a retirement fund. In the first scenario we assume the investments are all made in the name of one of the spouses (while still investing half their funds in a unit trust and the other half in a retirement fund). As the funds are all invested in one person’s name, only one of the tax-free exemptions will be used. There is taxable interest of R46 750 which means an additional tax bill of R18 700 reducing after tax cash flow.

For the second scenario, let us assume the same set of facts, except that the investments are split equally between the spouses and the investments within the retirement fund are more conservative and the investments in the unit trust are more aggressive, significant tax advantages can be realised. Each spouse will be making full use of their interest exemption of R27 500. This tax saving is without changes to the investment portfolio’s risk.

One can also counter possible higher taxes by changing your asset allocation in favour of non-interest-bearing assets, for example shares.

Reassess your overall portfolio exposure to cash, bonds, property and shares. It is critical to understand your asset allocation as this determines the risk and return in your portfolio.

Two Investment Risks

There are two kinds of risk of which to be wary. The first is inflation. Cash is usually a safe investment but inflation often results in investors investing themselves poor.

The second risk is capital loss. Investments in shares always fluctuate. However, those who focus on a long-term strategy will see positive results if they have invested in good shares.

If you don’t already have a money market or cash investment, now may be the time for some exposure to these investments. There are about 20 money market funds to choose from. A financial planner can assist in choosing a suitable one.

Investors should also consider dividend income funds in their portfolio if they have utilised the tax-free interest exemption.

Dividend income funds deliver returns in the form of dividends rather than interest and dividends are exempt from tax. They aim to deliver a better net after-tax yield than money market unit trusts.

Debbie Netto-Jonker, CFP, is founder of Netto Financial Services and was financial planner of the year in 2001.