Every year we extract from Trevor Manuel's Budget speech a metaphor to illustrate the Budget for you. Last year, we depicted Manuel as a musician.
This year, our cartoonist, Colin Daniel, has depicted him as a mountaineer. This is a result of Manuel's reference to a poem by Nigerian poet Ben Okri, which opens with the following lines: "There are no joys without mountains having been climbed."
During his 10-year tenure at the National Treasury, Manuel has sought to bring "joy" to many South Africans, particularly the poor. He told Parliament that many mountains of joy have been climbed, but there are still frontiers ahead of us.
At the end of every Budget speech, Manuel gives Members of Parliament a nominal gift to which he refers in his speech. He has given them fruit, trees and, last year, a CD to go with his music theme.
This year, Manuel gave MPs a booklet of the popular number puzzle game, Su Doku. He said it was food for the brain.
Manuel could well have said that his Budget is also food for the brain of every taxpayer. His Budget gives different tax breaks in different areas, and you should use the Budget's provisions to extract the best possible tax breaks offered to you.
This does not mean dodging tax. It means using the quite legitimate tax breaks to your best advantage.
Let's consider, in turn, the tax implications of investing in an interest-earning investment, 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 that from March 1 this year, there is an exemption from income tax on the first R16 500 (up from R15 000) if you are under 65, and an exemption of R24 500 (up from R22 000) if you are 65 or older, of interest income you earn annually. There is also an exemption from capital gains tax (CGT) on the first R12 500 (up from R10 000) of 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.
Interest-earning investments
Examples of interest-earning investments are RSA Retail Bonds, bank fixed-term deposits or money market accounts.
Income tax:
You do not pay tax on the first R16 500 (if you are under 65 years of age) or R24 500 (if you are 65 or older) of interest income that you earn annually. You are taxed at your marginal rate on any additional interest in a year.
Your capital is virtually guaranteed.
CGT:
There is no capital gain, so CGT does not apply.
Unit trust funds
Income tax: The "conduit principle" applies to investments in unit trusts. This means no tax is levied against any capital growth within the unit trust fund.
However, you, the investor, are taxed annually on any interest or foreign dividend income your investment in a unit trust fund earns, regardless of whether you take the income or allow it to be re-invested.
Different unit trusts have different cash holdings, depending on the type of fund. If a fund has any cash investments, it will pay out interest. Any interest you receive from your fund up to R16 500 or R24 500 is tax-free.
If you have foreign unit trusts (mutual funds), from March 1 the first R2 500 (up from R2 000) in interest and foreign dividends is tax-free. However, this amount is included in the total interest exemption. Any interest above the exemptions is taxed at your marginal rate of income tax in the year that the interest is paid or added to your investment.
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 cash in your units, and the first R12 500 of capital gains is exempt.
Any further gains are taxed at a maximum effective rate of 10 percent.
Retirement funds
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 nine percent (down from 18 percent last year).
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 R16 500 or R24 500 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 monthly 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.
Life assurance endowment funds
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 R16 500 or R24 500 individual interest exemption does not come into play.
As an individual taxpayer, you obviously benefit by investing in a life assurance vehicle if you have used up your R16 500 or R24 500 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 rate you, as an individual, pay for every rand above the R12 500 exemption. But the exemption does not apply when the life assurance company makes the CGT calculation.
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 assurance company trades the investments in any particular portfolio.
What this means for you
My view is that if you are not seeking guarantees on your capital and you want a market-linked investment with the potential for capital growth, you are better off investing in a unit trust fund until you have used up your income interest exemption, because costs are normally lower with a unit trust fund.
You must also look carefully at RAs and endowment policies. RAs have a number of tax advantages, which give them the edge over endowment policies. In particular, you are allowed to deduct up to 15 percent of your non-pensionable income (the portion of income not included in your pension fund contribution calculations) in contributions to an RA.
Furthermore, the interest earnings on RAs are taxed at a rate that is 21-percentage points lower than the rate for endowment policies. (The 21 percentage points are 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 nine 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, such as costs and investment risk, before you invest in it.
My take on the Budget as a whole: There will always be areas where more can be spent or less can be taxed, but I think Manuel has again brought a good balance of joy!
Get a head start before you pay any income tax
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.
If you are younger than 65:
- The first R40 000 of what you earn is tax-free.
- Add to that the first R16 500 you can earn in interest. This means the first R56 500 (R50 000 last year) you earn is tax-free.
Then:
- You can claim medical expenses not paid by your medical scheme,that amount to more than 7.5 percent (up from five percent last year) of your taxable income.
- All local dividends from shares
are tax-free.
- R2 500 of foreign interest and dividend income is tax-free. This makes up part of the total interest exemption.
- The first R12 500 of any capital gain is tax-free.
- You can give and/or receive as a gift R50 000 (up from R30 000 last year) every year, tax-free.
- Within limits, you can deduct contributions to tax-incentivised retirement savings from your taxable income.
If you are 65 or older:
- The first R65 000 of what you earn
is tax-free.
- Add to that the first R24 500 you earn in interest. This means the first R89 500 you earn is tax-free.
- You can claim all your medical expenses not paid by your scheme, including medical scheme contributions.
- All local dividends are tax-free.
- R2 500 of foreign interest and dividend income is tax-free. This makes up part of the total interest exemption.
- The first R12 500 of any capital gain is tax-free.
- You can give and/or receive as a gift R50 000 (up from R30 000 last year) every year, tax-free.
- You can, until the age of 69, deduct contributions to tax-incentivised retirement savings, within limits, from your taxable income.
Remember that if your spouse does not earn an income, you can structure your finances to double the interest income by donating capital, tax-free, to your wife.
Foreign pensions moratorium:
The moratorium on the taxation of pensions received by South African residents from foreign sources remains in place. The moratorium was declared when the government announced it was undertaking a review of the taxation of retirement savings. The future position on the taxation of foreign pensions could be included in the next version of the government's policy paper on retirement fund reform which is expected to be published shortly.
Click here for a worksheet that will help you to calculate your tax for 2006/7.