The Seven Ways Tax can unlock ‘The Eighth Wonder of the World’: Compounding Interest

Nobody enjoys paying tax, but since it’s our legal obligation, we may as well make the most of it by legitimately saving where we can. Because tax savings — even if fractional — compounded over prolonged periods of time can contribute significantly to any person’s financial position, writes Louis van Manen, BDO South Africa’s Tax Director.

It was Albert Einstein who described compounding interest as the ‘eighth wonder of the world’ saying, “he who understands it, earns it; he who doesn't, pays for it.” This concept isn’t only limited to ‘interest’ as we know it, but applies equally to anything that often or continuously adds to our wealth, such as reinvested dividends, reduced fees, and reduced taxes.

Compounding growth continues to fascinate me, and its effects are best illustrated with a basic example. Ignoring inflation, if you invest R 3,000 per month over a 40-year period at an annual rate of return of 5%, your future gross value of the investment will be R 4.5 million — compared to the total sum invested of only R 1.44 million. By increasing the annual rate of return by a mere 2.5 percentage points to 7.5%, the end result would double to R 9 million.

Once we understand this ‘Eighth Wonder’, we can also appreciate that ‘tax delayed’ equates to ‘tax saved’. And so, I present below the ‘Seven Tax Wonders’: a list of often either unknown or overlooked ways that, if applied correctly, could add those crucial percentage points needed to unlock the strength of the ‘Eighth Wonder’.

Wonder 1:  Retirement fund contributions

Often overlooked or regarded as a less exciting form of investment, pre-tax money can contribute significantly to the compounded growth of retirement savings.

Simply put, if you pay tax at the top marginal tax bracket of 45%, you pay R 55 for every R 100 investment. Retirement fund contributions qualifying for tax deduction means SARS is contributing to your savings now.

While you will face tax consequences by drawing from these retirement funds in future, the Eighth Wonder would have already done its work by then. Added to this, you will likely pay tax at a much lower rate then, especially if you plan your tax affairs carefully on an ongoing basis.

Wonder 2: Tax-free savings accounts

Our tax legislation limits the contribution a person can make into their tax-deductible annual retirement fund. So we must consider where we invest our after-tax money.

Natural persons can make annual investments up to R 36,000 into tax free savings accounts, with a lifetime limit of R 500,000.  If a person is able to reach this lifetime limit at a relatively early age and leave it untouched, it could easily grow to a couple million Rand by retirement age.  This can then supplement your retirement funding needs, tax free, while also aiding in reducing your marginal tax rate applied to other taxable retirement income.

Wonder 3:  Investing in vehicles exempt from capital gains tax (CGT)

Qualifying Collective Investment Schemes (CIS’s) and Real Estate Investment Trusts (REIT’s) enjoy exemption from CGT on the disposal of qualifying underlying assets.

Instead of investing in something directly, doing so via CISs and REITs, means the investor will not suffer CGT consequences every time an underlying asset is sold by the CIS or REIT. The CIS and REIT are accordingly able to reinvest pre-tax money following asset disposals.

The investor will be liable for CGT when disposing of the CIS or REIT investment, but by then, the Eighth Wonder should have already enhanced the value of the investment.

Depending on the nature and size of the asset, directly held investments can potentially be swapped by individuals, companies, and trusts for shares in CISs or REITs applying tax rollover relief.

Wonder 4: Investing in long-term insurance products

Not to be confused with life insurance, investments made in the form of a ‘policy’ (as defined through a licenced life insurance company) hold potential tax benefits for an individual.

While an individual policyholder enjoys exemption from CGT on the disposal of such qualifying investment policy, the life insurance company itself is liable for tax on its underlying investments. The difference, however, is that the life insurance company is taxed at flat income tax and CGT rates of 30% and 12% respectively. This compares favourably to the maximum tax rates applicable to individuals of 45% for income tax and 18% for CGT.

Investments in such qualifying policies make sense for individuals who find themselves on the wrong end of 30% on the tax rate table.

Wonder 5:  Direct investment in foreign assets

A natural person — or trust not carrying on a trade — who acquired and disposed of an asset in a foreign currency, isn’t liable for CGT on the part of a resultant capital gain due to the devaluation of the Rand over the holding period.

Thankfully, many locally-available assets serve as effective Rand hedges, but investors don’t enjoy the same CGT treatment. Capital gains realised on the disposal of assets acquired and sold in Rands generally attracts CGT in full, despite the fact that a subsequent portion may stem from a depreciating Rand.

So, if you’re considering investing in a foreign company listed on the JSE, there’s a CGT benefit in rather acquiring the shares in that company on a foreign exchange.   

Furthermore, individuals paying tax at a marginal rate below 45% may also end up paying tax on foreign dividends below the local dividends tax rate of 20%. This would however depend on the foreign country’s dividends tax level.

Wonder 6: Property investment allowances

Our tax legislation contains various tax allowances available for property used for specific purposes, or situated in designated areas, but the perception is that they are only reserved for companies with significant property investments.

In fact, a person owning five or more new and unused residential units situated in SA and used solely for the purpose of a trade qualifies for an annual 5% allowance on the cost of such units.

While not everyone can afford an investment of five new residential properties, five individual investors could instead collaborate to house five qualifying properties in a single company which then qualifies for the allowance.

Investors also tend to overlook the fact that properties used in a trade, especially smaller rental trades, often contain many separately identifiable unaffixed assets. Such assets could qualify for tax allowances in their own right. Allowances on assets of such a nature are generally permitted over relatively short periods of time. 

Wonder 7:  Housing your business in a company.

If you’re running a business as an individual in your own name you may be paying more tax than necessary. The top marginal income tax rate for individuals is 45%, while the collective income tax and dividends tax rate for a company and its shareholders is 41.6%.

In the latter case, the dividends tax part could also be deferred as dividends don’t need be legislatively declared at any specific point in time. Such a deferral will then add to the effect of the Eighth Wonder.

In many cases an individual is able to move their business into a company without triggering tax implications at that point in time by correctly applying tax rollover relief measures contained in our tax legislation.

Applying these seven wonders will greatly improve the ability of the ‘Eight Wonder’. But remember, any financial or investment decision requires a careful consideration of various factors, and tax is only one of them — so always seek out comprehensive investment advice before making an investment decision.