The lesser of two evils

When conducting your investment planning, do you ever stop to consider what tax you are paying? The ‘tax’ we are talking about here is Income Tax or Capital Gains Tax.

Let’s compare how the two affect your financial planning and how your adviser can help with tax obligations.

In terms of asset classes, cash and bonds will deliver interest income; this includes your money markets and call accounts. The returns on these asset classes will be subject to Income Tax,
which can be incredibly detrimental if the wrong product is used.

The Sale of Equity on the other hand is taxed as a Capital Gain - a tax that is not included in your annual income - and is taxed preferentially.

Simplistically, cash and bonds attract Income Tax, while Sale of Equity attracts Capital Gains Tax (CGT).

How you use these asset classes depends on your Income Tax rate, your risk profile and the investment vehicle you are using. As cash and bonds are so conservative in nature, it is considered the ‘safer’ investment,  just attracting more tax.

Example: Look at the highest income earner who is invested conservatively (Money Market) versus aggressively (Equity).

Lump sum: R2 000 000
Annual Return: 6% (R120 000)
Tax Rate: 45% (maximum 2017/18 rates)

The R120 000 the investor has earned is very pleasing however, also somewhat deceiving as this will be seen by SARS as taxable income.

The Investor (under age 65) will receive R23 800 interest exemption per annum, which means only R96 200 will be subject to tax.

After the 45% tax is applied, and interest exemption is included, the investor comes out with R76 710 after tax growth - paying R43 290 tax.

It is important to also consider that you might have other assets that might utilize the annual interest exemption

Now take the same scenario and move it into a high equity based Unit Trust.

Lump sum: R2 000 000
Annual Return: 6% (R120 000)
Tax Rate: 18%

The full R120 000 the Investor has earned is not subject to CGT as tax payers in South Africa are entitled to a R40 000 CGT exemption per annum. Therefore, only R80 000 will be subject to CGT.

The tax remaining is not subject to the 45%, but 18%. (18% is the effective individual CGT rate for our highest income earners). Ultimately, the Investor will only pay R14 400 tax and will come out with R105 600, a substantial difference.

The above does not include the effects of possible Dividends Withholding Tax, which now sits at 20%. It must also be mentioned that there are different tax rates for different vehicles and different policyholders (as per our previous article).

Despite this, some investors do not have the risk appetite or ability to be placed into a high risk investment profile and thus it is important that one discusses investment goals and unique needs with their Financial Advisor.