As National Savings Month draws to a close, let’s look at those savings or investment vehicles that the government encourages you to use, through tax breaks, and consider when and in what circumstances they are appropriate for you.
Tax-incentivised savings vehicles take three forms:
1. Retirement funds (including retirement annuities, pension and preservation funds). Your contributions are tax-deductible up to 27.5% of the bigger of your taxable income or gross income to a maximum of R350 000 a year. Dividends, interest and capital gains from the investment are not taxed. However, you do pay tax on the pension income from the annuity that you must buy with at least two-thirds of your retirement benefits on retirement. You may be able to choose the underlying investments, depending on the rules of the retirement fund, but the choice may be relatively limited.
2. Tax-free savings/investment accounts. Introduced three years ago to encourage people to save for the long term, these products are exempt from tax on dividends, interest and capital gains. Your contributions, of up to R33 000 a year, are not tax-deductible, and your lifetime contribution limit is R500 000. A wide spectrum of regulated savings vehicles or investments is open to you, from bank deposits to collective investment schemes. You can withdraw your investment at any time, subject to certain conditions, but the contribution limits are fixed, and you can’t exceed them to “top up” after a withdrawal.
3. Section 12J investments in venture capital companies. These are typically subject to a high minimum investment of R500 000 or thereabouts, and you must be invested for at least five years. As the legislation now stands, 100% of your investment is deductible from your taxable income, and there is no maximum investment amount. There are no tax breaks on returns. And, importantly, because you have deducted the full cost of the investment from your taxable earnings, the total proceeds of cashing in your investment are subject to capital gains tax (CGT) – your base cost is zero, because the cost has already been deducted for tax purposes.
Look at the bigger picture
Each of these vehicles has its advantages if you have done your homework. However, too often the words “tax-free” or “tax-deductible” blind investors to the whole picture, of which the tax saving is just a part.
Using retirement funds to save for your retirement is a no-brainer, because of the huge benefit of tax-deductible contributions going into tax-free, well-regulated investments.
But when it comes to tax-free savings accounts and section 12J investments, you need to look further than what you save on tax. The tax concession needs to translate into a genuine increase in what you get out.
For example, what would be the point of putting money in a tax-free account offering a return of 8% when a similar, discretionary investment gave you an after-tax return of 10%?
And getting a tax deduction of R500 000 or more on a section 12J investment may sound enormously appealing, until you consider that these are high-risk, relatively unregulated investments that could swallow your entire capital.
Tax-free savings accounts
Let’s delve a little deeper into these investments, commonly abbreviated to TFSAs, and see how much you can save in tax, but that, taking your circumstances and type of TFSA into account, you will not necessarily save:
1. Dividends. The withholding tax on share dividends was, from February last year, increased to 20%. You need to consider to what extent dividend distributions contribute to the return on your TFSA. This would be zero in a purely interest-bearing investment; about 15% in a high-equity multi-asset fund; maybe 30% in an equity fund; and possibly up to 60% in a listed property fund. So your saving on dividends tax would be zero in an interest-bearing account, about 3% of the return in a multi-asset fund (for example, on an annual return of 10%, about 0.3% would be dividend tax), about 6% of the return in an equity fund and up to about 12% of the return in a property fund. (Note that a property fund may invest partly in property investments known as Reits, which pay interest, not dividends.)
2. Interest. The tax you pay on interest is determined by your marginal income tax rate, and there are exemptions: currently R23 800 a year if you are under 65 and R34 500 if you are 65 or over.
If you had no other sources of interest income and had a TFSA paying interest of, for example, 10% a year, its value would need to be more than R238 000 (if you are under 65; R345 000 if 65 or over) before you began including any interest from the TFSA in your taxable income. And even then you may not pay tax on it – if you are a non-earning member of the family or earning less than R78 150 a year if you are under 65, less than R121 000 a year if between 65 and 75, and less than R135 000 if 75 or over.
3. Capital gains. You get capital gains only on equity and property investments, so if you’re in a purely interest-bearing TFSA, you will not save on CGT. You only realise a gain (and pay tax on it) when you withdraw money from the investment or switch investments, and, again, the tax you pay is determined by your marginal income tax rate. As an individual, you would include only 40% of the gain in your taxable income, and this would be after an exclusion of R40 000.
Don’t forget that TFSAs are designed primarily for your retirement, so it would probably be in your retirement that you would realise the gain by cashing in the TFSA or switching into an income-generating vehicle. By this stage of your life, your income tax burden may have decreased considerably and you may even be paying no tax (see figures above), particularly taking into account probable higher medical expenses, which are tax-deductible.
I am not knocking TFSAs and other tax-incentivised vehicles. What I am saying is that before you consider one, work out roughly what you would expect to save in tax over the term of the investment. Then compare how you would fare in a non-tax-incentivised vehicle that might have its own advantages. And only then make a decision.
My thanks to financial planners Wouter Fourie and Martin de Kock from Ascor Independent Wealth Managers in Pretoria for their kind input.