Every year Finance Minister Trevor Manuel gives you tax breaks in his annual Budget that are aimed mainly at helping you save but also at alleviating the financial pressures on the elderly.
You should use the Budget's provisions to create the most favourable tax scenario. This does not mean dodging tax. It means using the quite legitimate tax breaks to your best advantage.
Let's consider, in turn, the tax implications of investing in an interest-earning investment, a unit trust fund, a retirement fund and a life assurance endowment fund. Let's assume you have R100 000 to invest and can receive a return of 10 percent on your investment.
Interest-earning investments
Income tax:
From March 1 this year, the first R18 000 (up from R16 500) in annual interest earnings will be exempt from tax if you are under 65, while if you are 65 or older, the first R26 000 (up from R24 500) in annual interest earnings will be exempt from tax.
These exemptions are the total for any one tax year and cannot be applied separately to different financial products.
Examples of interest-earning investments include RSA Retail Bonds, bank fixed-term deposits or money market accounts.
Assuming your interest-earning investment produces a return of 10 percent on R100 000, you would earn R10 000 in interest, which is below the tax-exemption levels. Thus the amount is tax-free.
Capital gains tax (CGT): The investment has not made a capital gain, so CGT does not apply.
Unit trust funds
Income tax:
The conduit principle applies to investments in unit trusts. This means no tax is levied against any capital growth that occurs within the unit trust fund. However, you, the investor, are taxed annually on any interest or foreign dividend income your investment in a unit trust fund earns, regardless of whether you take the income or have it reinvested.
Different unit trusts have different cash holdings, depending on the type of fund. If a fund has any cash investments, it will pay out interest. Any interest you receive from your fund up to R18 000 if you are under 65 (or R26 000 if you are 65 or older) is tax-free. You are not taxed on any dividends paid out by locally listed companies whose shares are owned by your unit trust fund.
So again, assuming your unit trust investments of R100 000 earn interest of 10 percent (R10 000), you will not pay any income tax on those interest earnings.
If you have foreign unit trusts (mutual funds), from March 1 the first R3 000 (R2 500 last year) in interest and foreign dividends will be tax-free. However, this amount is included in the total interest exemption. Any interest above the exemption is taxed at your marginal rate of income tax in the year that the interest is paid or added to your investment.
CGT:
Most unit trust investments are intended to make capital gains. Again, the conduit principle applies, which means you, the investor, are liable for CGT on the gains made on your investment in the fund.
CGT applies only in the tax year in which you cash in your units, and the first R15 000 (R12 500 in 2006/7) of capital gains is exempt. Any further gains are taxed at a maximum effective rate of 10 percent.
You could switch some of your units between different unit trust funds each year to take advantage of the R15 000. This way you are setting a new base point for the future CGT liabilities. You must remember that the R15 000 cannot be accumulated; it must be used in each tax year.
Retirement funds
Income tax:
Retirement savings have been subject to three different tax approaches. These are as follows:
1. Contributions.
Within prescribed limits, your contributions to a registered pension fund, including a retirement annuity (RA), can be deducted from your taxable income. In other words, you defer tax on your contributions to a retirement fund until you retire. 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.
However, remember that you are tying up your savings until at least the age of 55 (the earliest retirement date allowed in most cases).
If, for example, you invest R100 000 in your tax-incentivised retirement fund and you can deduct the full amount from your taxable income, you are effectively receiving a tax break equal to your tax marginal rate. So, if your tax marginal rate is 38 percent, Manuel has in effect given you R38 000 as a tax rebate for the year in which you made the contribution.
2. Build-up.
The build-up of interest, net rental income and foreign dividends of all retirement funds was taxed at a rate of nine percent in 2006/7 (down from 18 percent in 2005/6). Manuel has scrapped this tax for the forthcoming tax year (2007/8).
3. Retirement.
When you retire, you are allowed to take up to one-third of the amount in your retirement fund as a lump-sum payout.
Of this one-third, about R120 000 is tax-exempt and the rest is taxed at your preferential average rate of taxation and not the harsher marginal rate of tax. The R18 000 (or R26 000) individual interest exemption does not come into play.
You are still deferring paying tax on the remaining two-thirds that is used to pay you a pension, because you pay income tax only when you receive your monthly pension. This means you are receiving investment returns on money that ordinarily would have been in the hands of the Receiver of Revenue.
CGT:
There is currently a moratorium on CGT on retirement funds.
Life assurance endowment funds
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.
The R18 000 (or R26 000 for over 65s) individual interest exemption does not come into play.
As an individual taxpayer, you obviously benefit by investing in a life assurance vehicle if you have used up your R18 000 (or R26 000) interest income exemption on other investments and have a marginal tax rate of more than 30 percent.
CGT:
Again, 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 10 percent rate you, as an individual, pay for every rand above the R15 000 exemption. But the exemption does not apply when the life assurance company makes the CGT calculation.
It is difficult to assess whether there is any advantage in this for investors, as the life assurance company pays CGT annually on capital gains made in the portfolio, as opposed to you paying when you realise a gain - for example, when you sell a unit trust fund.
Also, the amount of CGT paid will depend on how actively the life company trades the investments in any particular portfolio.
What this means for you
My view is that if you are not seeking guarantees on your capital and you want a market-linked investment with the potential for capital growth, you are better off investing in a unit trust fund until you have used up your income interest exemption. This is because the costs are normally lower on a unit trust.
If you rely on investments for income, you must use up all of your interest exemption by investing in interest-earning investments. For example, a couple over the age of 65 who are receiving a return of 10 percent could invest R520 000 in interest-earning investments to receive R52 000 a year tax-free. Remember that both spouses can claim the exemption. If one spouse has no investments, the other should donate money to his or her partner (you are allowed to do this without tax consequences) to derive the full tax advantage.
You must also carefully consider RAs and endowment policies. RAs have a number of tax advantages, which give them the edge over endowment policies. In particular, you are allowed to deduct up to 15 percent of your non-pensionable income (the portion of income not included in your pension fund contribution calculations) in contributions to an RA.
Furthermore, the interest earnings on RAs are exempt from income tax from March 1, while the annual interest earnings on endowment policies are subject to the 30 percent income tax rate on interest, net rental income and foreign dividends, as well as CGT at an effective 7.5 percent that a life assurer pays on your behalf.
You must also 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 55. So, if you will need your money before then, you should rather consider unit trusts.
Apart from the tax implications, you need to look at all the other advantages and disadvantages of an investment, such as costs and investment risk, before you invest in it.
My take on the Budget as a whole
Political freedom arrived in 1994, but economic freedom is still a way down the road. The social security and national retirement fund proposals will go some way to addressing the massive and totally unacceptable economic differences in our society. Only by narrowing these huge gaps in income can we be sure of a financially secure future.
With his astute management of the economy, Manuel has given himself the space to address these much-needed social spending reforms, which he intends to have in place before 2010.
And he is in effect killing two birds with one stone, because the government's proposed retirement reforms will also hopefully limit much of the seemingly endless plunder of the nation's retirement savings, with the Fidentia saga being only the latest example.
GET A HEAD START BEFORE YOU PAY ANY INCOME TAX
You can generate quite a lot of income before you pay any tax. The tax structure is particularly advantageous for pensioners who are 65 or older.
If you are younger than 65:
- The first R43 000 of what you earn is tax-free. (This is reflected in the R7 740 primary tax rebate.)
- Add to that the first R18 000 you can earn in interest tax-free. This means the first R61 000 (R56 500 last year) you earn can be tax-free.
In addition to the above:
- You can claim medical expenses not paid by your medical scheme that amount to more than 7.5 percent (up from five percent in 2006/7) of your taxable income.
- You can deduct or receive from your employer without paying tax R6 360 a year in medical scheme contributions as a single member, R6 360 for the first
dependant you register on your scheme and a further R3 840 a year for each dependent thereafter.
- All local dividends from shares are taxfree in your hands.
- R3 000 of foreign interest and dividend income is tax-free. This makes up part of the total interest exemption.
- The first R15 000 of any capital gain is tax-free.
- You can give and/or receive as a gift R100 000 (up from R50 000 in 2006/7) every year, tax-free.
- Within limits, you can deduct contributions to a tax-incentivised retirement savings scheme from your taxable income.
If you are 65 or older:
- The first R69 000 you earn is tax-free. This is reflected in the primary rebate of R7 740 and the secondary rebate of R4 680 for people of 65 and older.
- Add to that the first R26 000 you earn in interest. This means the first R95 000 (R89 500 last year) you earn can be tax-free.
- You can claim all your medical expenses not paid by your scheme, including medical scheme contributions.
- All local dividends are tax-free.
- R3 000 of foreign interest and dividend income is tax-free. This makes up part of the total interest exemption.
- The first R15 000 of any capital gain is tax-free.
- You can give and/or receive as a donation R100 000 (up from R50 000 last year) every year, tax-free.
- You can, until the age of 69, deduct contributions to tax-incentivised retirement savings, within limits, from
your taxable income.
Donations to your spouse
If your spouse does not earn an income, you can structure your finances to double the interest income by donating capital, tax-free, to your spouse.
Foreign pensions moratorium
The moratorium on the taxation of pensions received by South African residents from foreign sources remains in place. The moratorium was declared when the government announced it was undertaking a review of the taxation of retirement savings.