A Fin24 reader asks:
What is the effect of the different tax treatment of
products on the value of my investments?
Tom Blendulf, head of PSG Asset Management's Technical
Investment Centre, responds:
MOST investors assume that they benefit when some or all of
their retirement funding premiums are tax deductible. This is partly true - but
only if you are subject to a lower marginal tax rate once you have retired.
If investors knew with certainty that they would pay the
same tax rate before and after retirement and if the asset returns were taxed
in the same manner in either voluntary or compulsory products, they would be
indifferent as to which product to invest in.
What impact does compounding tax savings have on fund
Under current legislation, compulsory products are exempt
from capital gains tax (CGT), dividend withholding tax (DWT) – which replaced
the former secondary tax on companies – and income tax.
The interest you earn is therefore tax free, whereas it's
fully taxable at your marginal tax rate in a voluntary product.
I want to demonstrate the compounding effects of these taxes
on the investment value of these two product categories. We base our analysis
on the assumptions that:
- Both investors
invest R18 000 per year at the start of the savings period (25 years) and
increase the premium each year by the same rate as inflation.
- Both investors hold
a unit trust portfolio with 75% equity and 25% fixed interest split at all times
in both products.
- Equity total
returns are 15% per year.
- Fixed interest
returns are assumed to be 9% per year; the dividend yield is assumed to be 3%
per year; income tax rate is assumed to be 40%; CGT inclusion rate is assumed
to be 33%; DWT is assumed to be 15%.
Compulsory returns Voluntary returns
growth at 15% 15% net growth
12.96% net of CGT and DWT
interest at 9% 9% net growth
5.4% net of income tax
Total return 13.5% per year
11.1% per year
As can be seen from the table, under these assumptions the
tax exempt nature of the compulsory product results in an increase in annual
return of about 2%.
This results in the voluntary investment having a value of
R3 626 762.65 after 25 years, versus the compulsory product value of R5 366
This difference is solely due to the compounding effect of
the tax saving on the underlying asset returns.