Since we’re already being taxed to the max, it’s up to us to be smart about it. Here’s how you can take advantage of the tax breaks and how you can free up cash for additional investments, both of which will have a significant impact on your long-term returns.
Gifts from the taxman
Contributing to a retirement fund remains one of the most effective ways of reducing your income tax.
You’re allowed to contribute up to 27.5% of your annual income to a pension fund, provident fund or retirement annuity (RA) and deduct that contribution, thereby effectively lowering your tax.
Retirement funds are not considered part of your estate and are therefore not subject to estate duty. In that sense, they’re an excellent estate-planning vehicle.
An RA has additional benefits in that you can continue to contribute to the fund after retirement, and thus continue to benefit from the tax deduction.
You’re under no obligation to transfer the funds into a compulsory annuity when you retire, but if you do, you don’t have to pay capital gains tax (CGT) either. Be aware, however, that if you withdraw more than R500 000, you’ll have to pay a lump-sum tax. There’s also no tax on growth within retirement funds. Thanks to the power of compounding, this can have a significant effect on long-term investments.
A tax-free savings account is similar to a retirement fund in that there’s no tax on the growth within the fund, and you don’t pay CGT when you withdraw funds.
The other significant aspect of a tax-free savings account is that it’s not governed by regulation 28 of the Pension Funds Act, which moderates how and where funds can be allocated. You can allocate the total investment offshore. Although you can only contribute up to R33 000 a year, and a maximum of R500 000 in your lifetime, a tax-free savings account is still a vital component of any savvy investor’s portfolio.
Stay on track
Tax planning is integral to sound financial planning, but it’s equally important to review your investments and rebalance the asset allocation to stay true to your investment goals.
If you need to sell a portion of your investments, you may incur CGT. However, you are entitled to an annual R40 000 CGT exclusion each year. This means that you can sell to the extent of a R40 000 gain, without paying any CGT.
Alluring, but a little dangerous
Section 12J investments are new business ventures that the South African Revenue Service (Sars) deems to be beneficial to economic growth. Investing in such a venture is a great way to reduce tax, because you can deduct the total cost of the investment from your income. Depending on your tax bracket, you could save up to 45% on the purchase of the investment.
A big word of warning: 12J investments are not attractive from a CGT point of view. When you sell after the compulsory holding period of five years, you need to pay CGT on the full value of the investment, not just the gain (from a base cost of zero). This could offset any initial tax savings you might have made, so do your homework.
Take a long-term view
Endowment funds are another excellent way for high-income earners to reduce their tax liability since the income tax is capped at 30%, not 45%.
Likewise, for those in the highest tax bracket, the effective CGT rate within the fund is 12% as opposed to 18%. And if you withdraw from an endowment fund after the five-year restriction period, CGT doesn’t apply. Such funds also have estate-planning benefits: if a beneficiary has been nominated, executor fees don’t apply.
The gift of giving
Each individual taxpayer is allowed to make donations of up to R100 000 a year, before the 20% donation tax kicks in. A great way to double up on tax breaks is to contribute to a tax-free savings account in each of your children’s names - or your grandchildren’s. Remember, if the money is going towards school fees, Sars considers this a donation.
Investing is a multi-faceted process. While it’s wise to use the advice above to your advantage, remember that not all investment decisions should be based on tax. For example, if there’s a good reason to disinvest from a fund, the CGT implications shouldn’t deter you from doing so.
Making investment and tax decisions on your own can be daunting. Do consider enlisting a Certified Financial Planning professional with tax knowledge, who can give you objective advice and structure your investments to make the most of the available tax breaks.
Hardi Swart is the 2019/20 Financial Planner of the Year and director of Autus Private Clients.