Having recently discussed the building of an emergency fund and since the returns on this are likely to be largely interest, we’ll discuss the income tax effects associated with your emergency fund returns and what you need to know.
This is the first article that specifically deals with income tax. Over the course of this series of articles, we’ll discuss critical concepts of income tax and hopefully help you save some tax along the way too.
In a world where performance is almost always the product that is sold by an asset manager or investment professional, little thought is given to the after-tax efficiency of the outcome.
After-tax returns are generally never sold by financial services companies, as each investor has their own tax profile; each paying tax in accordance to their own specific set of circumstances which make it nearly impossible to guarantee a tax outcome for each investor. Gross returns (returns before the effect of income tax) are also often used as a metric for the calculation of fees charged on your investment. Which means that for an investment manager, there’s no reason to try to reduce the tax you pay. Which means that you have to do it.
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Your age, legal form of marriage and personal history affect the amount of tax you pay. Granted, there are certain outcomes that affect everybody equally, but managing your tax liability and making intelligent decisions around income tax is not something that a financial services company can do for you.
There is not always much that can be done to avoid paying tax, but there are a few opportunities that should be considered and used. Often, it’s not about paying as little tax as possible; rather it’s about remaining compliant. Being compliant generally means submitting tax returns, supporting documentation and responding to SARS’s queries in the prescribed manner, including timeously.
Interest income is generally taxable for all South Africans. It gets included along with all your other income to form part of your taxable income and is subject to income tax at your income tax rate. This means that if you are in the highest bracket of income tax, you will pay a marginal rate of 45% (as from 1 March 2017) on interest income earned. If you earn very little taxable income, your marginal rate of tax on interest income will only be 18%.
All South African individual taxpayers are able to earn a certain amount of interest income before it starts attracting income tax. This is called the interest exemption. If you’re under the age of 65, you can earn R23, 800 in interest per year before you start getting taxed for it. If you’re over 65 you can earn up to R34, 500 in interest per year without triggering income tax.
This is a fairly generous amount of tax-free interest income for someone under 65 to earn. With a hypothetical emergency fund of purely interest-bearing instruments and yielding approximately 6% per annum, a taxpayer could hold a balance of almost R400, 000 and not earn enough interest to push them into a tax-paying position.
It is unlikely that this would be the only interest income you would have earned during the year. You need to consider your aggregate interest during your year of assessment when considering the interest exemption relief. You would likely earn interest on any credit balances on your bank accounts and unit trust investments. How would you know how much interest you’ve earned from all these sources? You’ll get an IT3(b).
An IT3(b) is a certificate that financial institutions send to you at the end of every tax year, that tells you how much interest you received from them during that tax year. Not only are they required to send it to you, they are also required to upload that information directly to the South African Revenue Service (SARS).
This means that SARS has the ability to check that the interest income that you declare on your tax return matches the aggregate interest income as submitted by all the financial institutions from which you have received interest.
When completing your income tax return, you may or may not see the various pre-populated interest income amounts received from financial institutions on your return. You are, however, required to include these amounts in your tax return. Keep all IT3(b) certificates that get sent to you and set them aside for when you complete your tax return. SARS will automatically apply the interest exemption to your tax calculation and you don’t have to work out your ‘net’ interest for inclusion.
Given current money market interest rates and the value of the interest exemption, it is possible to earn a relatively risk-free and tax-free return on a R400, 000 emergency fund portfolio. Once interest income exceeds your exemption threshold, your net return is then subject to your marginal rate of tax. A 7% gross return subject to tax at 45% is now only a 3.85% net return, which does not provide a real return considering that inflation is nearer to 5%.
The previous paragraph was a bit technical, but it boils down to this: Once you’re earning enough interest to get taxed on it (more than R23,800 for under-65s, more than R34,500 for over-65s), you stop getting a real return from your emergency fund, because income tax eats all of your profit, and even starts nibbling on what you’ve already got.
So an emergency fund doesn’t generate wealth beyond a certain point. We’ll need some other ways to earn a real return on our investments and future-proof our finances. We’ll explore all of them in our upcoming articles. Bookmark WellSpent or subscribe to our monthly newsletter to continue your journey to personal finance mastery.
If you’ve read this far, your quest for knowledge on matters tax, or perhaps just your disdain for paying it, is remarkable. Consider the articles below if you’re interested.
We’ve written quite a few other great pieces on how tax affects your various investments and retirement outcomes – here they are:
If you have any questions on any of them, give us a shout!
 Tax avoidance is very different to tax evasion and you’d do well to know the difference. “Avoidance” is the ability to reduce taxes in a legal manner, to regulate one’s affairs in such a manner as to pay the least amount of tax as required by law. “Evasion” is an illegal act, the attempt to reduce tax by way of fraud, fictitious records and lying on your tax return. Tax evasion is punishable as a crime and can never be condoned.
 These interest exemption amounts generally change each year, however the law regarding this is currently going through change. We’ll keep you up to date for future changes.