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Tax rates and investments

May 21 2012 07:36

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 values?

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

75% equity

growth at 15%       15% net growth                            12.96% net of CGT and DWT

25% fixed

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 366 231.37.

This difference is solely due to the compounding effect of the tax saving on the underlying asset returns.

 - Fin24

investments  |  tax



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