Two investments may offer identical returns, but the realised after-tax returns can look substantially different, says Kelin Pottier, product development specialist at 10X Investments.
Understanding tax implications is key to structuring your investment decisions in the most tax-friendly way. Taxes reduce the returns on investments the same way that costs and fees do.
Few people really understand the taxes they pay, and even fewer interrogate the allowances and incentives that can materially change their bottom line – which is why, as an investor, these are the taxes you should be aware of, said Pottier.
Most people are familiar with income tax, which is known as Pay As You Earn (PAYE) in South Africa. This is calculated on a sliding scale where the more you earn, the higher your tax bracket and the more tax you pay.
The tax bracket you fall into is important as it determines your marginal tax rate, which is the rate of tax you pay for every additional rand of income you earn.
The first R23,800 of interest income you earn is exempt from tax (the exemption increases to R34,500 for people aged 65 and older).
Beyond that, any interest income you earn – whether it be from a savings account, a stokvel or a government bond – is included in your overall taxable income and taxed at your marginal tax rate. The same goes for rental income and REIT distributions.
Dividends Withholding Tax
Dividends, the portion of profits a company pays to its investors, are taxed at a flat rate of 20%. When paying a dividend to investors, a company automatically withholds the Dividends Withholding Tax (DWT) and pays it over to the South African Revenue Service (SARS) on behalf of investors.
If a company declares a dividend of R10 per share, it will pay a tax of R2 on each share to SARS, and investors will receive the remaining R8 per share into their brokerage account.
Capital Gains Tax
When you sell an investment in a collective investment scheme (ETF or unit trust) for more than you paid for it, the profit is known as a capital gain. The first R40,000 is exempt, but the rest is liable for Capital Gains Tax (CGT).
Capital gains are included in your total taxable income at a 40% inclusion rate and taxed at your marginal tax rate. A 40% inclusion rate means that 40% of the profit is taxed rather than the entire 100%.
Capital Gains Tax is realised only when you sell an investment. If you don’t sell, you don’t pay any CGT. If you sell only part of your investment, you pay CGT on the portion sold.
For example, Sindi earns R33,000 a month (R396,000 a year). Her marginal tax rate is 31%. She buys five shares in a JSE Top 40 ETF for R100 each (total R500).
The market has a great run and the shares in the ETF are now worth R200 each. Sindi decides to sell three of the ETF shares (for R600) and makes a profit (that is, a capital gain) on those three shares.
If Sindi sells her ETF shares today, she earns a profit of R300 (R600 from the sale minus a cost of R300). The R300 profit is included in her taxable income at the 40% inclusion rate (R300 x 40% = R120). The R120 is taxed at Sindi’s 31% tax rate, which amounts to R37.20.
How to minimise tax and maximise your investment returns
There are not many ways around paying your due in terms of tax, although South Africans can reduce their tax paid and maximise their investment returns by investing in tax-efficient products, such as retirement funds.
Contributions to a retirement fund are tax-deductible, and growth on investments in a retirement product is free from tax on interest earned, dividends, or capital gains.
Consider two people, Sindi and Samantha, who each earn R400,000 per year at a 31% marginal tax rate. Sindi contributes R3,000 per month to her retirement annuity, amounting to an annual contribution of R36,000. Samantha does not contribute to a retirement fund.
By contributing to a retirement product, Sindi reduced her taxable income by R36,000 and saved R11,160 in tax. Individuals qualify for tax relief on the lower of 27.5% of their earnings and R350,000.
By not paying tax on the growth of investments within a retirement product, investors are able to compound the tax benefits over time as they effectively “reinvest” their tax saving and earn compound growth on these savings.
There’s a good reason that saving for retirement is incentivised since the more we’re able to support ourselves in our old age, the less of a burden falls on the state and/or other members of society, such as family and friends of the ill-prepared. Tax incentives on retirement savings are one of the greatest tools available to South Africans.
Paying tax is an important obligation to society, and being tax-efficient is a duty to yourself and your family. Every rand of tax saved is a rand earned.
The content herein is provided as general information. It is not intended as nor does it constitute financial, tax, legal, investment or other advice.
- By Kelin Pottier, product development specialist at 10X Investments