09 Feb Extend thinking to tax efficient funds
The shift towards tax efficient investments
In our previous article, we considered the effects of tax on different types of investments. Considering the impact tax may have on investments may make a big difference in the long term. It is essential to do a proper needs analysis and return comparison using an investor’s relevant tax rates.
Tax on income or growth in discretionary investments is payable when earned, so for investors who pay high marginal tax rates it can be very valuable to look at investment returns after-tax to determine their most beneficial investment options. For these investors, the shift towards tax efficient investments becomes a compelling option. Tax inefficiency can reduce investment returns by up to 41% for individual investors, as an example. Simplistically, a 10% return can be reduced to 6%.
But it’s not easy to identify a tax managed fund
No category to separate them from the rest
We define tax managed funds as unit trust funds measured according to an after-tax benchmark. What makes it difficult to spot tax efficient funds is that there is no category that separates them from the rest.
It is not a requirement for fund managers to show after-tax returns
While internationally there is a focus on showing both pre- and after-tax returns, investments in South Africa are measured on a pre-tax basis. Pre-tax returns remain the benchmark for investors in deferred tax products such as pension and provident funds – and rightly so. For investments which are better assessed after-tax, the onus lies on the investor or financial advisor to do the maths.
Measuring tax efficiency
Below are some questions to ask to determine how tax efficient a fund is for different types of investors.
1. What is the return made up of?
Is it growth or income? Capital gains tax will apply to capital growth on units when units are sold. Income can take the form of interest, rental or dividends and will be taxed accordingly.
2. What tax rates apply to the components of return for different types of investors, assuming the highest tax rates?
3. What will the returns look like after-tax?
The illustration below shows what returns can look like after-tax. We assume a once-off investment of R1 000 000 and the tax rates in the table above. Bear in mind that the total return after-tax may differ vastly per type of investor, depending on the components of the return. For example, a return of 8% consisting entirely of interest could equate to an after-tax return of 4.72% for an individual (41% income tax rate) or 5.76% for a company (28% income tax rate).
Making the sums work
Ideally, all returns should be shown pre- and post-tax, allowing investors and their advisors to easily determine which funds service their specific needs the best. Until that happens, the onus will remain on the investor or advisor to identify tax efficient funds before making an investment selection based on specific needs. One method of identifying tax efficient funds may be to identify funds with after-tax benchmarks.
DISCLOSURE This document is proprietary to Ora Fund Managers (Pty) Ltd (Ora). It is for information only and may not be distributed or used for any other purpose. It does not address the circumstances of any particular person or entity and is not a recommendation or advice in relation to any transaction or investment. This document should not be relied on without proper advice from an independent financial adviser. We have taken care to ensure that the information is accurate and not misleading but do not guarantee its accuracy or correctness or that it will not change. Ora will not be held liable for loss, damages or expenses by any person or entity as a result of that party relying on or failing to act on any of the information provided.
ASSUMPTIONS ON ILLUSTRATIVE RETURNS Returns are annualised. Annualised returns are period returns scaled to a period of one year. We cannot guarantee that these calculations will be accurate for all factual returns. The rand value of return on investment assumes that the investor earned this return for the entire investment period. The investor makes one withdrawal of the full investment at the end of the period. The money is invested for a year and the return is the same every day of the year. We ignore interest exemptions and capital gain exclusions.
ASSUMPTIONS ON TAX RATES The tax rates for trusts are based on the assumption that the trust income is distributed to beneficiaries who are individuals. Returns for a company assume that they are exempt from dividends tax.