Tax season is in full swing in South Africa at the moment given the looming tax year end in three weeks’ time. Investors are being inundated with marketing material, advertisements and media articles on various options from the different product providers. The three most popular product options are Retirement Annuities, Tax Free Investments, and now S12J companies.

Retirement Annuities

Investors are able to contribute up to 27.5% of their taxable income or R350,000 (whichever is the lower amount) and qualify for a full deduction against their taxable income. These contribution amounts apply to all their retirement savings be they RAs, pension or provident funds. The employer’s contribution is also included here. Retirement annuities in particular are attractive beyond the income tax deduction in that returns within the RA are free of all taxes, allowing the investor to compound higher net returns. They also do not form part of an investors’ estate and therefore attract no executor’s fees or estate duty.

Investors just need to ensure that they are not invested in expensive, old generation retirement annuity products. Investors also need to be cognisant of the fact that this is an illiquid investment and that they can only access funds from age 55. At that point there will be tax implications in the form of various retirement funds taxes.

Tax Free Investments

This is also a reasonably new addition to the retail investment landscape, and offers investors a higher degree of flexibility relative to RAs. Returns within a TFI attract no tax therefore allowing investors to compound a higher net return over time. Contributions are limited to R33,000 per annum per investor. This may reduce the appeal of this product to higher income earners. However, over the long term investors may be able to build up a meaningful pool of tax free money within a product like this. The benefits of TFI products are certainly back end loaded and increase with time. Treasury may increase the life time limit of R500,000 in future, so investors will do well to get their TFIs in place as soon as possible.

S12J

S12J investments have become all the rage in the past two years, in the face of rising tax rates at the top end, and the limiting of RA contributions. S12J (of the Income Tax Act) investments allow investors to deduct 100% of the value of their investment in the tax year in which they made that investment. However, investors must remember that the FULL proceeds of their investment will be subject to Capital Gains Tax. While the advertising and marketing has focused on the tax deduction upfront, investors need to be aware of the tax treatment at the end (i.e. the full amount of the investment proceeds being subject to CGT).

Two critical factors for potential investors in S12J investments;

  1. Investors need to be invested for at least 5 years in order to keep their tax deduction. However, investors should not see these as traditional 5 year investments as they would a 5 year endowment. These investments can be messy and disorderly at the end, and investors may need to be prepared to remain invested for another year or two while the company unwinds. We advise clients to rather take a minimum of a 6-7 year view, maybe even longer, when going in. That way they stand a chance of increasing their final return. Investors should therefore think clearly about how long they are able to go without access to the funds they want to invest in 12J companies.
  2. Returns quoted in many 12J marketing products are often based on the maximum tax deduction of 45% being achieved by the investor. Investors with lower marginal tax rates need to adjust their expectations downwards. Consider the IRR (internal rate of return) for the same expected return for lower rates. 45% tax rate – 16% IRR; 40% tax rate – 14% IRR; 30% tax rate – 11% IRR. That is a massive return difference when compounded over time.

As a result we would usually recommend that investors look beyond the tax incentive when deciding if or how much to invest in a 12J company. Once they are clear on their liquidity requirements, and the possible lack of order at exit stage, and what their actual tax rate is, then they should make a call and take the upfront tax break.

When it comes to the issue of mitigating tax, investors need to remain vigilant around the other issues impacting on their choice of investment product. While they may succeed in avoiding one tax, they may end up running head first into another one down the road. Avoiding tax should never be the sole reason for investing in anything. It is but one of many considerations.