How to generate an inflation beating income
Mukesh writes: I have R3.2-million deposited into a money market account. I earn 4.9% interest annually that is compounded at end of each month. How can I double my returns with reduced tax effect?
I am planning on resigning from my company and moving back to the city I grew up in but I will have to take a pay cut. Hence I need this money in order to supplement my income.
I do not want to tie up my cash in property and investments as they do not give you monthly cash. Assets cannot buy bread at the local store, cash does.
Maya replies: This is a very big decision you are making and it is imperative that you make the right financial decision because a mistake at this stage of your relatively young life will see your nest egg dramatically diminished. I would recommend you sit down with a good financial adviser who can help you plan your income carefully and to be realistic about what you can actually afford to draw down.
Some points to consider:
Cash does not keep up with inflation. In fact right now you need a return of 5.3% just to match the inflation rate. That means you would need to reinvest the interest to ensure that your lump sum continues to retain its buying power. So you are already going backwards and destroying your nest egg.
With an inflation rate of 6% your buying power halves every 15 years. In other words if you draw all the interest from your lump sum, the purchasing power of your lump sum will only be R1.6-million in fifteen years’ time assuming inflation remains at 6%.
One could argue that on an individual basis inflation is actually far higher and closer to 10%. In this case your money will halve in less than 10 years.
You can increase your cash returns by investing in something like the RSA Retail Bonds which pay around 8% for a five-year term. However that will be fully taxable.
Ideally you need to be generating a total return of around 12% so that you can draw down 6% and leave 6% to make sure your capital keeps up with inflation. Only growth assets like property and shares can offer those types of returns and they can actually provide an income to buy bread at the shops!
You could invest in several properties and rent them out for income. The income would be taxable but your asset would grow over time as would your rental income.
Unlike interest on cash whose returns are determined by the Reserve Bank and can be extremely volatile, rental income will increase in line with inflation so that your income retains its buying power.
A good rental return is around 8% of the value of the property, so for example on a R500 000 property you would receive a rental income of R40 000 a year. However the following year your rental would increase by 6% to R42 400 and the following year it would increase to R44 944. A similar investment in the RSA Retail Bond would provide a static return of R40 000.
You could invest in a portfolio of shares that provides dividends. The benefit of dividends is that they will only be taxed at 10% and not at your full income tax rate making them far more tax efficient.
Dividends are lower than cash returns initially (around 4%) but over time like your rental, they will increase with inflation (in fact usually well above inflation) and soon over-take your cash return providing a tax-efficient income with growth on the underlying asset.
Although in the short-term shares can be volatile, if you are only focused on the income/dividends the volatility of the actual share price will not be an issue and over time it will outperform cash.
A good strategy would be to create an investment portfolio that has property, shares, cash and bonds which provide you with different streams of income which can be combined to provide a monthly income.
Read more news, blogs, tips and Q&As in our Smart Money section. Post questions on the site for independent and researched information