You may have noticed we’re a tad tax obsessed at the moment. February is the end of the tax year. We find this thrilling! Since the introduction of tax-free investment accounts, we’ve been especially pumped about our tax returns. In this post we’re going to explain the taxes for which you are liable when you buy an exchange-traded fund (ETF) outside of a tax-free environment. Hopefully this will convince you to go tax-free instead.
Dividend withholding tax
A dividend is a cash payment you receive when a company in which you are invested wants to share some of that profit. It’s one of the two-and-a-half ways in which shares make money. When you buy an ETF, you are buying a collection of companies, many of which pay a dividend. The ETF issuer collects those dividends and holds on to them for you until it’s time to pay out. You receive all of the dividends in one go, instead of one at a time. You also get the interest the ETF issuer earned on those cash amounts while they were pooling your dividends.
Naturally, the government wants in on this money-making action, which is why they charge dividend withholding tax (DWT). This is an ongoing tax that you pay for as long as you hold the investment. In South Africa, the DWT rate is 20%. This tax gets deducted from your dividend before the dividend gets paid out to you. On the one hand this is great, because you never actually see that money, so you don’t feel it. On the other hand it’s awful, because you don’t realise how much money you’re missing out on.
When you buy your ETF in a tax-free investment account, you don’t pay a dividend withholding tax on local investments. Unfortunately, this is not true for offshore investments. Since tax gets paid on the dividend before its distributed and other countries aren’t in on the tax-free investment accounts, you still pay the difference between the local DWT rate of 20% and whatever the offshore tax rate is.
Tax on interest
Interest income is half of the two-and-a-half ways shares make money. Tax on interest income works differently from DWT, which gets deducted from your dividend payment and is capped at 20%.
Interest income is added to your annual income from other sources, like your job and your side-hustle. That puts you in a certain tax bracket and the tax you pay is at that tax rate. This is what people mean when they talk about your “marginal tax rate”. The good news is you don’t pay tax on the first R23,800 interest you receive, regardless of whether you invest via a tax-free investment account or not. The bad news is income received from property ETFs is considered interest income and taxed at your marginal rate. The even worse news is your marginal rate can be much, much higher than 20%.
If you love property ETFs above all others, it’s especially important to buy these within tax-free investment accounts for this reason.
Capital gains tax
Capital gains tax (CGT) is a tax you pay when you sell your shares at a profit. This is a tax you only pay only once and only on the profit you make, not on the value of the transaction. The good news is your first R40,000 of profit isn’t taxed. The bad news is everything after that is taxed at 40% of your marginal rate. To work that out, multiply your marginal rate by 0.4.
Within your tax-free savings account, you are not taxed on any of the profits you make when you sell shares. Add the money you save here to all the DWT and interest savings and the case for tax-free investing pretty much makes itself.
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