Three taxes punish South Africans for saving and investing

Investors who do the “right things” by saving and investing their money are forced to watch as the South African Revenue Service (SARS) eat into their returns with three different taxes.

Understanding how each tax works can help investors make better decisions and avoid sacrificing investment growth simply to reduce their tax bill.

On the Honest Money podcast, Galileo Capital Executive Director and co-founder Warren Ingram and Money Marx founder Pieter de Villiers explained that the tax treatment depends on how an investment generates a return.

The three main areas are interest and other income, dividends paid by companies, and capital gains from the sale of assets.

Capital gains tax applies when an investor sells an asset for more than its base cost, De Villiers explained.

For example, if someone invests R100,000 in JSE-listed shares and sells them 10 years later for R150,000, the R50,000 gain may be subject to capital gains tax.

However, if the investment is still worth R100,000 when it is sold, there is no capital gain and therefore no tax on the disposal.

De Villiers said capital gains tax is generally the most favourable form of investment tax. “If you have to choose one type of tax, that’s it,” he said.

This is because only 40% of a natural person’s net capital gain is included in taxable income. The individual’s marginal income tax rate is then applied to that amount.

This means the effective capital gains tax rate for individuals ranges from 7.2% to 18%, depending on their marginal tax rate.

There is also an annual capital gains exclusion, meaning the first portion of an individual’s capital gains for the tax year is exempt from tax.

However, De Villiers explained that investors need to distinguish between investing and trading.

If someone buys and sells shares frequently, SARS will view it as trading income rather than capital gains. As a result, the income will be taxed according to the person’s marginal tax rate.

Dividends and interest

Investors who own shares in dividend-paying companies face a different form of tax, De Villiers explained.

When a company earns a profit, it can either reinvest it in the business or distribute it to shareholders as dividends. Dividend tax is levied at 20%.

The tax is withheld before the dividend reaches the investor. This means an investor receiving a R10,000 dividend would receive R8,000 after the 20% withholding tax.

The dividend is then declared on the individual’s tax return, but is exempt from further income tax.

De Villiers described dividends as the second-most favourable investment tax after capital gains tax, since dividends are taxed at a flat rate of 20%. However, he said the “worst kind of tax” is charged on interest.

Interest earned from investments such as bank accounts, money market funds, and bonds is included in taxable income and taxed at the individual’s marginal tax rate, subject to the annual interest exemption.

For individuals under 65, the first R23,800 of interest income is exempt from tax. The exemption is higher for individuals aged 65 and older.

Any taxable interest above the exemption is added to other taxable income and taxed according to the applicable marginal rate.

Ingram explained that the problem becomes particularly clear when interest returns are slightly higher than the cost of living.

“If you’re earning 8% a year and your cost of living is running at 7% a year, what’s actually happening is you pay tax on the 8%,” he said.

“So you’re probably netting out five or so, and your cost of living is going up faster than the growth on your money.”

This means an investor can feel financially secure even as the real value of their money falls.

One mistake investors must avoid

Although tax efficiency matters, Ingram warned investors against making tax the primary consideration when choosing investments.

Some investors buy expensive products simply because they offer tax advantages. “Don’t try to save tax and then have lousy investments on an after-cost basis,” he said.

Instead, investors should focus on achieving their financial goals and then consider how to structure those investments efficiently.

When building a portfolio, De Villiers said investors should consider three major factors: asset allocation, tax efficiency, and costs.

“First is asset allocation. Make sure that what you’re investing in is appropriate for the goal,” he said. The investment time horizon should also determine how much risk an investor takes.

Only after considering this should investors look at how they can achieve their desired outcome in the most tax-efficient way possible.

This is where investment vehicles such as retirement annuities, endowments, and tax-free savings accounts can become important.

The third consideration is cost. De Villiers said investors should avoid paying for expensive products and services when a lower-cost alternative can achieve the same objective.

The goal, he said, should be to build a portfolio with the right asset allocation, appropriate risk, and sensible costs while also making use of available tax efficiencies.

One of the biggest mistakes investors can make is allowing fear of tax to stop them from using their money.

De Villiers said he often sees people become so focused on avoiding tax that they make decisions that run counter to their own financial interests.

For example, an investor approaching retirement may need to reduce their exposure to equities and start drawing income from their portfolio. However, investors may refuse to sell assets to avoid triggering capital gains tax.

“That’s how far people go sometimes. And they’re missing the point of what money is supposed to do,” De Villiers said. “It’s supposed to help us live the best lives we can.”