When completing my 2022/23 income tax return, it became clear very quickly just how punitive interest income now is from a tax perspective.
Read all our interest rate coverage here.
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The repo rate has more than doubled, from a low of 3.5% as recently as October 2021 to 8.25%, following the 50 basis-point rate hike in May 2023, as illustrated in the table below. While placing the economy and the consumer under increasing pressure, the higher interest rates on offer have been welcomed by savers and, no doubt, the South African Revenue Service (Sars)!
Graph 1: Recent path of the South African repo rate
Source: South African Reserve Bank.
Sars exempts from income tax any interest income earned from a South African source by any individual under 65 years up to R23 800 per annum, and individuals 65 and older, up to R34 500 per annum. (There has been no change to these amounts since the 2014 year of assessment.) The net effect is that the amount you can hold in an interest-yielding bank or money market account before being subject to income tax at your marginal tax rate has reduced materially. This is illustrated in the following table, where we have used the repo rate as a proxy for the interest earned on a savings account:
Source: Ninety One calculations.
So, the tax-free amount that you could invest in a bank or money market account before incurring income tax fell by approximately 40% from the 2021/22 tax year to the 2022/23 tax year. This comes at a time when retail household bank deposits have reached all-time highs, as South Africans increasingly hide in cash.
The South African Reserve Bank’s BA900 economic returns data shows that household bank deposits totalled R1.7 trillion at the end of July 2023. This is significantly higher than the long-term average – and up more than R80 billion over the year to date. At the same time, retail investor assets held in money market unit trust funds amounted to more than R200 billion, as at 30 June 2023. Furthermore, South Africans are holding on to their bank and money market account investments for longer.
Many of us will only fully understand the implications of this when we finalise our 2022/23 income tax returns and receive an unpleasant demand from Sars for payment due on interest income earned above the exemption. Table 2 provides a simple illustration of the effect on individuals under 65 years of age and those 65 or older, who are subject to a marginal tax rate of 45% for differing amounts invested in a money market account.
Table 2: Illustration of the estimated increased interest income tax paid
Source: Ninety One calculations.
While we cannot do anything now to mitigate this ‘unplanned’ expense for the 2022/23 tax year, we may need to reconsider our financial affairs going into the 2023/24 tax year, especially as you can see from Table 1 that the current amount above which you will be subject to income tax has fallen even further.
What to do, what to do?
We will need to look to alternative, more tax-efficient solutions, as hiding in cash and paying away up to 45% of any excess interest income earned is not the most sensible savings or investment strategy. Unfortunately, your options are limited. Everyone should be maximising their annual contribution to their tax-free savings account (TFSA), but at an annual limit of only R36 000 this is not going to make a dent.
In addition, a TFSA must be viewed as a long-term investment, and therefore the underlying investments should be growth oriented. Anyone with excess savings and a marginal tax rate greater than 30% should consider an endowment or sinking fund policy, such as the one available from Ninety One Investment Platform (IP). This is because interest income earned within a sinking fund policy is taxed at 30%, and not your individual marginal tax rate. Ninety One IP also takes care of all tax administration relevant to the investment, including calculating and paying tax on your behalf.
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A common concern is that you must remain invested for a minimum period of five years. Importantly, however, the Ninety One sinking fund policy does allow one surrender and one interest-free loan within that five-year period, so you do retain two liquidity options should you require some, or all of your funds. And if you take a loan, you have the option to repay it at any time and receive the tax benefits of a matured policy after five years, where you can enjoy a regular income stream on which no income tax is payable (only capital gains tax will apply).
The following graph illustrates the faster-compounding benefits on total investment returns by comparing a R1 million investment held directly in the Ninety One Diversified Income Fund versus firstly, a bank account, and secondly, the same Ninety One Diversified Income Fund investment, but this time held via the Ninety One IP sinking fund policy for the 5 years ended 30 September 2023.
Graph 2: The benefit of a Ninety One IP sinking fund policy
Source: Morningstar and Ninety One calculations.
In summary, a direct investment in the Ninety One Diversified Income Fund returned R1.197 million after fees and taxes, almost R40 000 more than the R1.157 million return of a bank account. However, the real uplift is when investing in the Ninety One Diversified Income Fund via a Ninety One IP sinking fund policy. Here the after-fees-and-taxes return is R1.256 million, almost R60 000 more than the direct Ninety One Diversified Income Fund investment. This equates to an additional net return of 0.98% per annum. Earlier this year we announced a 1-year 11% fee reduction for the platform fee class of the Ninety One Diversified Income Fund. We have reduced the H-class annual management fee from 0.45% (ex VAT) to 0.4% (ex VAT), effective from 1 April 2023 to 31 March 2024. This is to further encourage investors sitting in cash to switch to a fund that is well placed to assist them in achieving more meaningful cash-plus returns over time.
Invest, or pay off your bond?
Finally, a related question we often get asked is: “Should I invest any surplus income or rather put it towards paying off my bond earlier?” When the repo rate was as low as 3.5%, it did not present much of a performance hurdle for an alternative investment to outperform, even when taking the additional tax consequences into account. However, the current repo rate of 8.25% and related prime lending rate of 11.75% present a material performance hurdle. This is especially true when accounting for the additional return required from an equity investment to compensate for
dividend withholding tax at 20% and capital gains tax at 18% (for individuals). As a result, we estimate that an equity investment needs to deliver approximately an additional 2.5% per annum to earn an after-tax return equivalent to the guaranteed return of paying off your bond. This is a tough ask and explains why it makes sense to pay off debt at these interest rates.
The value of independent advice
Given the very real financial and tax planning consequences of this decision, we strongly recommend that investors seek professional financial planning, investment and tax advice, tailored to their individual circumstances.
Paul Hutchinson is sales manager at Ninety One.
