How you are taxed on your investments

THREE main taxes apply to investments: you are taxed on income earned from interest, there is a withholding tax on share dividends, and you are taxed on a capital gain when you trigger a capital gain event. These taxes are all lower than your marginal income tax rate, which is the highest bracket rate for your annual earnings level.

However, different types of products incur different rates of tax, notes Kobus Kleyn, a Certified Financial Planner with the Financial Planning Institute of South Africa (FPI) and a tax practitioner with the South Africa Institute of Taxation. For example, in an endowment policy, the life insurance company pays tax at a rate of 30% on certain portions of the fund’s growth on your behalf, which is favourable for wealthier individuals earning at the 45% marginal bracket – or even at any rate above 30%.

As for pension or provident fund investments or retirement annuities, any growth – whether it is interest, dividends, or capital gains – is not taxed while it is growing in the fund. And on withdrawal at pensionable age, it is taxed at a lower rate, because your income drops post-retirement.

The further benefit is that your deductions for contributions to a retirement fund are deducted at your current marginal tax rate. “This means the South African Revenue Service (Sars) refunds you at your highest rate, which is why a retirement contribution is so effective,” says Kleyn.

COMPARING THE THREE TAXES

Comparing the taxes on investment growth, he says, the most favourable kind of tax is capital gains tax (CGT). “For individuals, this will not exceed the ‘effective’ rate of 18% per year.

“The second most favourable tax rate is the 20% on share dividend distribution, known as dividend withholding tax. Both the effective rates of capital gains and dividends taxes are typically far lower than most people’s marginal tax bracket rates, which is encouraging for the investment planner,” he says.

“After that, tax rates on local investment interest income (as accrued from cash investments), become less favourable. After the annual R23 800 exemption (or R34 500 for over-65s), the individual is taxed at their ‘marginal tax bracket rate’.”

From a tax perspective, Kleyn ranks Reit (real estate investment trust) income derived from property funds as least tax efficient, because there is no exemption available (unlike for bank interest), and you are taxed at your (highest) marginal tax bracket rate.

With CGT, a R40 000 exclusion is available annually for individuals, which is a critical factor in tax planning. Equity-based investments – whether held in unit trust or ETF form, or as individual shares – allow greater flexibility than fixed real estate ownership, says Kleyn. He emphasises that, as an asset class, real estate is neither inferior nor superior to equity-based unit trusts or shares, as each serves a role in terms of risk profile and diversification of the portfolio.

“I encourage investors who hold unit trusts, ETFs, or a share portfolio for long-term gain to rebalance their portfolios annually. Trigger a capital gain by switching or selling funds or shares that have done well, to use the

annual R40 000 capital gains exclusion.” He adds that even if your capital gain exceeds the R40 000 exclusion, and you owe a bit of CGT, it means you’ve at least fully used this exemption. By reinvesting it elsewhere, you create a new “base cost” for CGT calculation purposes. This is sound tax planning, he says.

As a side note, he recommends that you keep your shares invested for at least three years before doing this, or you risk being taxed on the disinvestment on a speculative “income/ revenue” basis.

In contrast to your ability to minimise CGT on equities, consider the situation if you sell an investment property (a second property that is not your primary residence). Sars allows the R40 000 annual exclusion only in the year of sale – it does not accumulate for each year that you own the property. For example, if you bought such a property in the early 2000s, at R300 000, and you sell it for R3.5 million today, you will have made a “paper” capital gain of R3.2m, which means you face a sizeable CGT burden. Unfortunately, Sars does not truly consider the effects of inflation on your property, so the R300 000 acquisition cost is not converted to its present value.

“If South Africa had zero inflation, keeping an asset for this length of time would not have been problematic,” says Kleyn.

NEED HELP?

Enlist the services of a tax practitioner. Check that the practitioner is registered with a recognised controlling body and with Sars, as required by the Tax Administration Act. You will find the list of currently recognised controlling bodies on the Sars website. This includes the FPI, so a financial adviser who is registered with the FPI can help you.