Pasop vir Jan Taks en rente opbrengste
July 19, 2018
Buitelandse beleggings: Makliker gesê as gedaan
September 17, 2018

Tax on interest might be costing you

Tax on interest might be costing you

The last 3 years has seen a lot of uncertainty in the market. You would not be blamed for having lost faith in your investment plan and harbouring serious thoughts of moving your funds away from growth assets into a “safe” investment vehicle.

The old adage that growth doesn’t occur in a straight line offers little comfort while your investment returns are dwindling and has seen no improvement for some time.

It is therefore only natural for your ears to prick when there is a promising offer on the radio or in the newspaper of an investment with a 10% guaranteed return without the pain of any market fluctuations. Like many things in life, the first impression isn’t necessarily the right one and a further analysis is required to make a judgement. There are several factors at play which could lead to different conclusions such as your marginal tax rate, current mandate and your long-term growth needs.

The impact of taxation

Do you fully understand the difference between tax on capital growth versus tax on interest income? Let me illustrate the effect of tax on a 10% fixed deposit investment of R3 million versus the same investment in a balanced mandate with an average return of 10.8% per annum.

The following assumptions were made:

  • Annual income from other sources: R300 000 a year;
  • Age: younger than 65 years;
  • Growth assets average return = 13% per annum;
  • Interest-bearing investments’ (this includes bonds) average growth rate = 8% per annum; and
  • Balanced mandate consists of 56% growth assets and 44% income or interest investments.

After the tax man is finished with you, the return on your fixed-deposit investment decreases from 10% to 6.41%. What seemed like a good investment in the beginning, now barely beats inflation. In the balanced mandate you certainly don’t side-step the tax man, but the impact is a lot smaller.

There is a big difference between tax on interest income and tax on capital gains. Interest income will be added annually to your income tax return, whether you have received the income or not. Individuals younger than 65 years are allowed an annual exemption of R23 800 and if you are over the age of 65 you receive an exemption of R34 500. Due to the large inclusion of interest to the taxable income it moves this investor to the 39% tax rate. Keep in mind that this individual loses the growth on the taxable part, because SARS compels you to pay it annually whether he receives it or not. On the other hand, capital gains tax (CGT) is only payable upon the sale of the investment.

The effective CGT rate is a lot less than tax on interest. An individual receives an annual rebate of R40 000, and only 40% of the remaining capital gains are added to your income for the year.

Therefore, an individual will possibly pay up to 45% (the highest tax rate) on his interest income, but currently no more than 18% (40% of capital gains x 45% – the highest tax rate) on capital growth. Given the above, if you combine growth assets and interest-bearing assets, not only is the volatility of your investments substantially lowered, but tax implications are reduced too.

The price you have to pay to completely eliminate volatility, and as such only invest in cash instruments, is therefore very high.

Keep in mind

There are a few other aspects to keep in mind, since the above example addresses only one scenario:

  • The example above makes sense if you have an investment horizon of 5 years or longer. Growth assets can and will show negative growth for short periods of time and there may be times when it performs worse than money market type investments for uncomfortably long periods (as was the case recently). This can be emotionally challenging for some investors who often react irrationally which leads to poor outcomes.
  • The price you’ll pay for peace of mind can become significant over time. If you invested R100 000 17 years ago in the money market fund of one of the country’s leading asset managers, the fund value would’ve been R370 585 today, while in the same asset manager’s balanced fund it would’ve been R1 116 595 (more than three times as much). This is before the effect of tax is taken into account, which would result in an even greater gap.
  • The impact of interest income tax versus CGT becomes greater as your investment value and/or annual taxable income increases. For smaller amounts the above analysis isn’t relevant and fixed deposits can possibly be a good alternative.
  • Average returns from money market investments are currently about 7.6% per annum. If you see an offer for 10% return or more, you must realize that there’s an element of risk and/or lack of liquidity. Make sure you understand exactly what it entails.
  • If the word “guaranteed” gives you a comforting sense of security, you need to banish the feeling before it takes hold. A guarantee is just as good as the institution behind it. We don’t have to look too far into the past to be reminded how “safe” institutions can fail overnight.
  • Rental income from the lease of property has the same tax implications as interest, except that there is no exemption.

If you are uncertain about the tax implications of your investments, ask an accountant or certified financial planner to explain the differences. It will most certainly impact your investment decisions.

Elmie de Jager is a certified financial planner and wealth manager for ProVérte Wealth & Risk Management. Contact her at info@proverte.co.za.

Although all possible care was taken in the drafting of this document, the factual correctness of the information contained herein cannot be guaranteed. This document does not constitute advice and anyone planning on taking any financial action based on this document, is strongly advised to first consult with their personal financial advisor. ProVérte Wealth & Risk Management is an authorised financial service provider with FSP no. 5966.

Show Buttons
Hide Buttons