Having recently discussed the building of an emergency fund, let’s now look at the tax on your interest.
Why don’t financial services companies tell you exactly what you’re going to get?
In a world where performance is almost always the product that is sold by an asset manager or investment professional, little thought is given to the after-tax efficiency of the outcome.
After-tax returns are generally never sold by financial services companies, as each investor has their own tax profile; each paying tax in accordance to their own specific set of circumstances which make it nearly impossible to guarantee a tax outcome for each investor. Gross returns (returns before the effect of income tax) are also often used as a metric for the calculation of fees charged on your investment. Which means that for an investment manager, there’s no reason to try to reduce the tax you pay. Which means that you have to do it.
Everyone is taxed differently
Your age, legal form of marriage, income and legal entities all affect the amount of tax you pay. Granted, there are certain outcomes that affect everybody equally, but managing your tax liability and making intelligent decisions around income tax is not something that a financial services company can do for you.
There is not always much that can be done to avoid paying tax *, but there are a few opportunities that should be considered and used. Often, it’s not about paying as little tax as possible; rather it’s about remaining compliant. That generally means submitting tax returns, supporting documentation and responding to SARS’s queries in the prescribed manner, including timeously.
* Tax avoidance is very different to tax evasion and you’d do well to know the difference. “Avoidance” is the ability to reduce taxes in a legal manner, to regulate one’s affairs in such a manner as to pay the least amount of tax as required by law. “Evasion” is an illegal act, the attempt to reduce tax by way of fraud, fictitious records and lying on your tax return. Tax evasion is punishable as a crime and can never be condoned. Be warned! 🙂
An easy-to-understand introduction to South African income tax
Interest income is generally taxable for all South Africans. It gets included along with all your other income to form part of your taxable income and is subject to income tax at your income tax rate. This means that if you are in the highest bracket of income tax, you will pay a marginal rate of 45% (as from 1 March 2017) on interest income earned. If you earn very little taxable income, your marginal rate of tax on interest income will only be 18%.
How much tax-free interest can you earn?
All South African individual taxpayers are able to earn a certain amount of interest income before it starts attracting income tax. This is called the interest exemption. If you’re under the age of 65, you can earn R23,800 in interest per year before you start getting taxed for it. If you’re over 65 you can earn up to R34,500 in interest per year without triggering income tax.(These may change from year to year)
This is a fairly generous amount of tax-free interest income for someone under 65 to earn. With a hypothetical emergency fund of purely interest-bearing instruments and yielding approximately 6% per annum, a taxpayer could hold a balance of almost R400,000 and not earn enough interest to push them into a tax-paying position.
Don’t forget other sources of interest
It is unlikely that this would be the only interest income you would have earned during the year. You need to consider your aggregate interest during your year of assessment when considering the interest exemption relief. You would likely earn interest on any credit balances on your bank accounts and unit trust investments. How would you know how much interest you’ve earned from all these sources?
You’ll get an IT3(b).
An IT3(b) is a certificate that financial institutions send to you at the end of every tax year. It tells you how much interest you received from them during that tax year. Not only are they required to send it to you, they are also required to upload that information directly to the South African Revenue Service (SARS).
This means that SARS has the ability to check that the interest income that you declare on your tax return matches the aggregate interest income as submitted by all the financial institutions from which you have received interest.
When completing your income tax return, you may or may not see the various pre-populated interest income amounts received from financial institutions on your return. You are, however, required to include these amounts in your tax return. Keep all IT3(b) certificates that get sent to you and set them aside for when you complete your tax return. SARS will automatically apply the interest exemption to your tax calculation and you don’t have to work out your ‘net’ interest for inclusion.
So can I make any money from the interest I get from my Emergency Fund?
Given current money market interest rates and the value of the interest exemption, it is possible to earn a relatively risk-free and tax-free return on a R400,000 emergency fund portfolio. Once interest income exceeds your exemption threshold, your net return is then subject to your marginal rate of tax. A 7% gross return subject to tax at 45% is now only a 3.85% net return, which does not provide a real return considering that inflation is nearer to 5%.
The previous paragraph was a bit technical, but it boils down to this: Once you’re earning enough interest to get taxed on it (more than R23,800 for under-65s, more than R34,500 for over-65s), you stop getting a real return from your emergency fund, because income tax eats all of your profit, and even starts nibbling on what you’ve already got.
An emergency fund doesn’t generate wealth beyond a certain point. We’ll need some other ways to earn a real return on our investments and future-proof our finances.
Cash investments such as money market accounts, call accounts, fixed deposits are all great as part of your investment strategy, but not for long term wealth creation!
Tax free investments are a great however, but as you have seen from the above calculations, you would need to wait some time for your TFSA to grow sufficiently to actually gain the benefit of not paying tax on the interest. (More on this soon)