During his eight-year reign at the National Treasury, Trevor Manuel has sought to close the loopholes in the tax system, but this does not mean he stings you for every rand you earn.
Manuel has left gaps and opportunities. In fact, he has widened some of the gaps and increased the opportunities in his latest Budget.
Manuel's 2004/05 Budget - as with his previous Budgets - emphasises the need for you to consider how tax affects different investment vehicles.
Let's consider, in turn, the tax implications of investing in a bank term deposit or money market account, a unit trust fund, a retirement fund and a life assurance endowment fund. Let's assume you have R100 000 to invest and can get a return of 10 percent on your investment.
Don't forget there is an exemption from income tax on the first R11 000 (if you are under 65) and R16 000 (if you are 65 or older) of interest income you earn annually, and an exemption from capital gains tax (CGT) on the first R10 000 of the capital gains you make each year. These exemptions are the total for any one tax year and cannot be applied separately to different financial products.
A bank term deposit or money market account
Income tax:
You do not pay tax on the first R11 000/R16 000 of interest you earn. You are taxed at your marginal rate on any additional interest in a year. Your capital is guaranteed.
CGT:
There is no capital gain, so CGT does not apply.
A unit trust fund
Income tax:
The "conduit principle" applies to investments in unit trusts. This means no tax is levied against any investment growth within the unit trust fund.
However, you, the investor, are taxed on any interest or foreign dividend income your investment in a unit trust fund earns, regardless of whether you take the income or simply allow it to be re-invested.
Unit trusts have until now paid out a fair amount of interest, because they were required to keep five percent of their holdings in cash investments. However, any interest you receive from your fund up to R11 000/R16 000 is tax-free. Any interest above this amount is taxed at your marginal rate of tax in the year that the interest is paid or added to your investment.
Remember that your interest earnings from a pure equity unit trust fund are limited, while the interest earnings from a bond-based or asset allocation fund can be substantial, because these funds use more interest-earning investments.
CGT:
Most unit trust investments are intended to make capital gains, but have no capital guarantees. 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 only applies in the tax year in which you actually cash in your units, and the first R10 000 of capital gains is exempt.
Any further gains are taxed at a top effective rate of 10 percent.
A retirement fund
Retirement savings are 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 to earn additional investment returns.
This deduction does not apply to provident funds.
However, you must remember you are tying up your savings until at least the age of 55 (the earliest retirement date allowed in most cases).
2. Build-up
The build-up of interest, net rental income and foreign dividends of all retirement funds is taxed at a rate of 18 percent.
3. Retirement
When you retire, you are allowed to take 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 R11 000/R16 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 pension. This means you are receiving investment returns on money that ordinarily would have been in the hands of the Receiver.
CGT:
There is currently a moratorium on CGT on retirement funds. This will come under consideration in the government's current review of the taxation of retirement funds.
A life assurance endowment fund
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 R10 000/R16 000 individual interest exemption does not come into play.
The 30 percent tax rate on the investment is not completely accurate, as life assurance companies are allowed to claim some cost deductions against the tax.
As an individual taxpayer, you obviously benefit by investing in a life assurance vehicle if you have used up your R11 000/R16 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 you, as an individual, pay for every rand above the R10 000 exemption.
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.
My view is that if you are not seeking guarantees on your capital and want a market-linked investment with the potential for capital growth, you are better off in a unit trust fund until you have used up your R11 000/R16 000 income interest exemption.
You must also look carefully at RAs and endowment policies. RAs have a number of tax advantages which definitely give them the edge over endowment policies. In particular, you are allowed to deduct up to 15 percent of your non-pensionable income (portion of income used to make pension fund contributions) in contributions to an RA.
Furthermore, the interest earnings on RAs are taxed at a rate that is 12-percentage points than the rate for endowment policies. (Twelve percentage points is the difference between the 30 percent tax rate a life assurer pays on your behalf on the interest, net rental income and foreign dividends earned by an endowment policy and the 18 percent tax rate paid on the same returns earned by an RA.)
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 consider unit trusts or an endowment policy.
Apart from the tax implications, you need to look at all the other advantages and disadvantages of an investment before you invest in it.
My view on the Budget as a whole: Manuel makes an excellent horticulturist. May his forests flourish!
Manuel's gift to you
Debbie Tickle, a tax partner at KMPG, says 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.
In this case:
- The first R50 000 of what you earn is tax-free.
- Add to that the first R16 000 you earn in interest - which means the first R66 000 is tax-free.
- You can claim all your medical expenses.
- All local dividends are tax-free.
- If your partner is also 65 or older, you can structure your finances to double the tax-free amount.
If you are under the age of 65:
- The first R32 222 of what you earn is tax-free.
- Add to that the first R11 000 you earn in interest - which means the first R42 222 is tax-free.