You are entitled to structure your financial affairs to derive the best possible deal and pay the least amount of tax that the Income Tax Act permits.
In fact, every year Finance Minister Pravin Gordhan provides you with tax breaks in the Budget that are aimed mainly at helping you to save some tax by behaving properly, such as saving for retirement.
There are also tax breaks aimed at alleviating the financial pressures on the elderly and on people with low incomes.
Some breaks – such as the marginal rate of tax you pay with the income ranges for each additional, higher level of tax – are automatic, but others, such as the exemptions, may take careful planning if you want to derive the best advantage of what is on offer.
The tax exemptions and deductions affect different financial products in different ways. Let us assume that you invest R100 000 and earn a return of 10 percent a year from each of the following four products:
1. INTEREST-EARNING INVESTMENTS
Income tax. From March 1, the first R22 800 in annual interest earnings are exempt from tax if you are under 65. If you are 65 or older, the first R33 000 is exempt. By the way, this year’s Budget is the first in many years in which the exemptions have not been increased.
The exemptions are for the total interest earnings for a single tax year and cannot be applied separately to different financial products. The interest must be from generally available products, such as RSA Retail Bonds, bank deposits and money market accounts.
With a return of 10 percent on R100 000, you would earn R10 000 a year in interest, which is below the tax exemption levels. Thus the amount is tax-free.
Dividends withholding tax: Your investment has not earned any dividends, so you are not liable for dividends tax.
Capital gains tax (CGT). There is no capital gain, so no CGT is due.
2. COLLECTIVE INVESTMENTS
Collective investment schemes include unit trust funds, exchange traded funds (ETFs) and participation mortgage bonds.
Income tax. The conduit principle applies to collective investments. This means that no tax (on capital or interest) is levied on returns in the portfolio. You, the investor, have in the past been taxed annually on any interest and foreign dividend income you receive, regardless of whether you take the income or reinvest it.
All local interest, as well as foreign interest and dividends, you receive from your collective investments are subject to the tax-free exemptions. Apart from the interest exemptions detailed above, you are also entitled to an exemption of R3 700 out of the total interest exemption for foreign interest and dividend income.
So again, assuming a 10-percent return (R10 000) on your R100 000, you will not pay any income tax on the interest earnings. Any interest above the exemption is taxed at your marginal rate of income tax in the year the interest is paid or added to your investment.
Dividends withholding tax. From April 1 this year, you will pay dividends withholding tax of 15 percent on local dividends.
CGT. The conduit principle applies – you are liable for CGT on the gains made on your investment, but only when you sell units. CGT applies in the tax year in which you cash in your units. The first R30 000 (up from R20 000 in 2011/12) in capital gains or losses is excluded. Any further gains are taxed at a maximum effective rate of 13.3 percent (up from the 10 percent set when CGT was introduced in 2001).
You could switch some of your units between different unit trust funds each year to take advantage of the R30 000 exclusion. If you did this, you would set a new base point for your future CGT liabilities.
The R30 000 exclusion is not accumulative; it applies in each tax year only.
3. RETIREMENT FUNDS
Income tax. South Africans’ retirement savings are subject to three different tax approaches:
1. Contributions. Within prescribed limits, your contributions to a registered pension fund, including a retirement annuity (RA), can be deducted from your taxable income. This allows you to use money that would otherwise have been paid to the Receiver of Revenue to earn additional investment returns. This deduction does not apply to provident funds.
Remember that with an RA you are tying up your savings until at least the age of 55 (the earliest age at which you can withdraw the money in most cases). If you invest R100 000 in a tax-incentivised retirement fund and you are allowed to deduct the full amount from your taxable income, you are effectively receiving a tax break equal to your marginal rate of tax. So, if your marginal rate is 38 percent, you are not paying tax on R38 000 for the year in which you made the contribution of R100 000.
You can claim a deduction each year for contributions to an occupational retirement fund to the greater of 7.5 percent of retirement-funding income or R1 750.
You can claim a deduction each year for contributions to an RA fund to the greater of: 15 percent of taxable income other than retirement-funding income; R3 500 less current deductions to an occupational pension fund; or R1 750.
These maximums are due to change. From March 1, 2014, you will be allowed to deduct as a percentage of the higher of your employment income or your taxable income, 22.5 percent if you are below the age of 45, with a maximum deduction of R250 000, or 27.5 percent if you are 45 or older, with a maximum deduction of R300 000. The deduction will include your and your employer’s contributions, plus fund administration costs and the premiums for group life assurance cover.
2. Build-up. The build-up of interest, net rental income and local and foreign dividends in retirement funds before retirement is exempt from tax.
3. Retirement. When you retire, you are allowed to take up to one-third of the amount in your pension fund as a lump sum payout. You are permitted to withdraw up to R315 000 tax-free (R300 000 in 2010/11); the second R315 000 is taxed at 18 percent and the third R315 000 at 27 percent. Any further amount you withdraw over R945 000 is taxed at 36 percent.
You are still deferring paying tax on the remaining two-thirds or more that is used to pay you a pension in future years, because you pay income tax only when you receive your pension each month. This means you are receiving investment returns on money that ordinarily would have been in the hands of the Receiver of Revenue.
Dividends withholding tax. This tax does not apply to retirement savings, whether you are building up your savings or receiving a pension.
CGT. There is a moratorium on CGT on retirement funds.
4. LIFE ASSURANCE ENDOWMENT POLICIES
Income tax. Tax of about 30 percent is paid on your behalf by life assurance companies on the interest, net rental income and foreign dividends earned on your investment, so you lose out on the tax exemption on interest earnings.
But you benefit by investing in a life assurance vehicle if you have used up your exemption on interest income on other investments and you are on a marginal tax rate of more than 30 percent.
If, on the other hand, your marginal tax rate is below 30 percent, you are being penalised.
Dividends withholding tax. From April 1 this year, dividends withholding tax of 15 percent will be deducted from local dividends paid to any life assurance endowment portfolio.
CGT. The tax is paid annually on your behalf by the life assurer at an effective rate of 7.5 percent, which is lower than the top effective rate of 13.3 percent you may pay for every one rand above the annual exemption of R30 000.
But the exemption does not apply when the life assurance company makes the CGT calculation. You win or lose, depending on how often the life company trades the portfolio.
SOME THINGS TO FACTOR INTO YOUR CALCULATIONS
If you are not seeking guarantees on your capital and you want a market-linked investment with the potential for capital growth, you should consider investing in a unit trust fund or an exchange traded fund (ETF) until you have used up your exemptions on interest income. This is because the costs are normally lower on unit trusts and, in particular, ETFs.
If you rely on investments for an income, you should use up your entire interest exemption by investing in interest-earning investments. For example, a couple over the age of 65 who receive a return of 10 percent a year could invest R660 000 in interest-earning investments to receive R66 000 a year tax-free. Both spouses can claim the exemption.
You should carefully consider retirement annuities (RAs) and endowment policies because of the tax advantages, which may give them the edge over other products. This is even more so because of the exemption from dividends withholding tax in RAs.
For example, the interest earnings on RAs are exempt from income tax and capital gains tax (CGT), while endowment policies are subject to an income tax rate of 30 percent on interest, net rental income and foreign dividends, as well as CGT at an effective 7.5 percent, which a life company pays on your behalf.
However, you should consider the length of time your money will be tied up in an investment. For example, you cannot draw on an RA until you reach the age of 55. If you require access to your money earlier, you should rather consider a collective investment.
Apart from the tax implications, you need to look at all the other advantages and disadvantages of an investment, such as guarantees, costs, contractual conditions and investment risk, before you invest in it. For example, compare a unit trust management company RA with a life assurance RA, which penalises contribution reductions.
WHAT YOU CAN EARN BEFORE THE TAXMAN CLAIMS HIS SHARE
You can generate quite a lot of income before you have to pay any tax. The tax structure is particularly advantageous for pensioners who are 65 or older, and there are additional tax breaks for people over 75.
If you are younger than 65
The first R63 556 (up from R59 750) of what you earn is tax-free. This is reflected in the primary rebate of R11 440 (up from R10 755). On top of that, the first R22 800 (unchanged from last year) you earn in interest is tax-free. Last year, an investment of R304 000 in a two-year RSA Retail Bond, which paid interest of 7.5 percent a year, would have taken you to the R22 800 limit. This year, because a two-year bond pays 7.25 percent, you can invest R314 482. The rebate and the tax-free interest combined mean the first R86 356 (R82 550 last year) you earn can be tax-free. In addition:
* Dividends are taxed at 15 percent, but not if the shares that pay the dividends are held in a tax-incentivised retirement fund. Dividends are taxed at a much lower rate than is interest, which is taxed at your marginal rate of income tax.
* R3 700 of foreign interest and foreign dividend income is tax-free. This makes up part of the total interest exemption of R22 800.
* The deductions you were allowed to claim last year for medical scheme contributions that you have paid have been replaced with tax credits – or a rebate against your tax.
The tax deductions allowed you to claim a tax benefit equal to your marginal rate multiplied by the deduction, whereas the tax credit is set at 30 percent of the rand amounts (and adjusted for inflation).
Everyone who pays medical scheme contributions therefore claims the same amount: R230 a month for contributions paid for yourself, plus R230 a month for contributions paid for your first dependant and R154 a month for each additional dependant.
You can also claim against your taxable income medical scheme contributions and unrecouped medical expenses that exceed certain revised limits.
Medical scheme contributions that are considered are those that exceed the tax credit for the primary member multiplied by four (R230 x 4 = R920 a month). Add these contributions and any unrecouped medical expenses together and, where they exceed 7.5 percent of your taxable income before any deductions, you can claim the excess as a deduction.
* The tax credit can be used to offset a subsidy of your medical scheme contributions from an employer that is added to your income as a taxable fringe benefit.
* The first R30 000 (up from R20 000) of any capital gain each year is tax-free.
* You can give and/or receive as a donation R100 000 (unchanged since 2006/7) every year tax-free, reducing potential estate duty.
* You can, within limits, deduct contributions to a tax-incentivised retirement savings scheme from your taxable income.
If you are 65 or older
The first R99 056 (R93 150 last year) you earn is tax-free. This is reflected in the primary rebate of R11 440 and the secondary rebate of R6 390 (R6 012 last year). On top of that, the first R33 000 you earn in interest is tax-free. For example, last year you could invest R440 000 in a two-year RSA Retail Bond, which paid interest of 7.5 percent a year, before exceeding the exemption. This year, because the two-year bond pays 7.25 percent, you can invest R455 172.
The total rebate of R17 830 and the tax-free interest combined means the first R132 056 (up from R126 150) you earn can be tax-free. In addition:
* You can claim all medical scheme contributions and expenses not paid by your medical scheme. A new system of tax credits for medical expenses is due to be introduced in 2014.
* R3 700 of foreign interest and dividend income is tax-free. The R3 700 makes up part of the R33 000 total interest exemption.
* The first R30 000 of any capital gain is tax-free.
* You can give and/or receive as a donation R100 000 tax-free every year, reducing potential estate duty.
* You can, within limits, deduct contributions to a tax-incentivised retirement fund from your taxable income.
* You will pay dividends withholding tax of 15 percent, but any shares held within a retirement-funding vehicle will be exempt from the tax.
If you are 75 or older
The first R110 889 you earn is tax-free. This is reflected in the primary rebate of R11 440, the secondary rebate of R6 390 and a further rebate of R2 130. As with people aged 65 and older, the first R33 000 you earn in interest is tax-free. The combination of the total rebate of R19 960 and the interest exemption means you can earn R143 889 tax-free.
You receive all the other tax benefits for people who are 65 years or older.
Donations to your spouse
If your spouse does not earn an income, you can structure your finances to double the tax-free interest income by transferring capital, tax-free, to your spouse. But this must be justifiable, such as a contribution to your spouse’s retirement savings. If it is done solely for tax purposes, the interest earnings will be added to the donor’s income.