Tax 102

In the last post we looked at tax basics. In this post we'll look in more detail at how the tax calculation works with some examples, get to grips with tax terminology and some more information about the various deductions and types of tax. This post may be a bit long - I hope you won't find it too taxing!

Tangled up in terminology 

It's easy to get tangled up in terminology and abbreviations. Hopefully the list below will help!
Photo credit: Gavin Schaefer (CC-BY 2.0)

• CGT - Capital Gains Tax. This is a fairly benign tax (relatively speaking) on profits made on the sale of certain assets.
• IRP5 - this is the document issued to you by an employer that pays tax over to SARS in the form of PAYE.
• IT3a - a document issued to you by an employer that does not pay tax over to SARS in the form of PAYE.
• IT3b - a document issued by financial service providers (banks, investment management firms etc.) where the total interest and dividends that you have received is reflected.
• IT3c - a document issued by financial service providers indicating everything you will need to calculate your capital gains (base costs of shares / unit trusts etc. sold as well as their selling price).
• ITA34 - the actual tax assessment issued by SARS. This comes as an annoying pdf that seems impossible to open in anything other than Adobe Reader.
• ITR12 - this is the tax return that you will complete as an individual.
• PAYE - Pay As You Earn: tax paid over to SARS by your employer on a monthly basis.
• SARS - the South African Revenue Services (aka, "the tax man").
• UIF - Unimployment Insurance Fund. A deduction of 1% of your gross income is paid over to SARS and this is matched by your employer.

These documents should be sent to you by your financial people by email - you can always request them if you haven't received them. You need to save them somewhere sensible because you could be asked to send them in. This is called being audited and it isn't scary: as long as you are well prepared.

Retirement deductions

Pensions

If you have an employer pension, then your employer can contribute up to 20% of your income (from this employer) towards your pension and you can contribute and deduct up to 7,5% of your retirement funding income (income received from an employer through which you have a pension) from your taxable income.

Retirement annuities

You can deduct up to 15% of non-retirement funding income (income received from all sources other an employer through whom you have a pension) from your taxable income if you contribute to a retirement annuity.

Let's look at an example to see what this looks like for someone who earns R200 000 gross salary from their employer as well as R100 000 of additional income from other sources:

The maximum amount that they will be allowed from both pension fund contributions and retirement annuity fund contributions is R15 000 provided they contribute at least these amounts. In addition, the employer could be contributing up to 20% (although they're more likely to be contributing something more in line with the 7,5% that you can contribute).

Rules relating to retirement products will be changing soon, but not for the 2015 or 2016 tax years. Possibly (hopefully!) for the 2016/2017 tax year. When these new rules kick in, it's likely that you will be able to deduct 27,5% of your taxable income through your contributions to pension funds, retirement annuities and provident funds.

Donations

As mentioned in a previous post on giving, you are able to deduct up to 10% of your taxable income if you make donations to certain public benefit organisations. You will need to get a certificate from them for all donations made in a given tax year. 

Capital Gains Tax

I'm not going to go into all the details here as Capital Gains Tax can get fairly complicated, so I'll just stick to the basics which cover most situations. I'll refer to buying and selling shares as an example, but this also applies to unit trusts, ETFs or even property investments.

• Each year you can get R30 000 of profit related to the sale of an asset tax free. In other words, when you sell shares, they need to have increased by more than R30 000 in value before you would start paying tax on them. This amount increases to R300 000 in the year of death which is fair as many assets will need to be sold at this stage.
• Once you've deducted the allowed annual exclusion you multiply your profit by the inclusion rate for individuals, which is 33.3% at the moment. So effectively, only one-third of your profits above R30 000 form part of your taxable income. This still needs to be multiplied by the tax rate associated with your tax bracket to work out the tax you would pay on these capital gains.
• When you sell your primary residence, the first R2 million in profit is exempt from capital gains. 
• If you trade shares frequently, then SARS will class you as a trader and any profit you make will be classed as part of your income - this would mean no reduction through the R30 000 exclusion or only including 33.3% through the inclusion rate. All profit will form part of your taxable income in this case. As far as I am aware you need to hold onto shares for at least six months in order not to be seen as a trader.

Here's what the capital gains tax calculation looks like: 

Let's look at an example. Let's say you sell R200 000 worth of shares that you originally purchased for R120 000. Let's further assume that you're sitting in the 25% tax bracket before the capital gains tax is factored in and that all of the taxable portion lies in this bracket.

For more on capital gains tax, here's the comprehensive guide prepared by SARS.

Medical tax credits

If you belong to a medical aid, then from your calculated tax obligation you can subtract R257 for yourself, and your first dependent and R172 for each additional dependent per month that you belong to the medical aid in a given tax year. So for a family of four, the person who pays for the medical aid could deduct 12 X (R257 + R257 + R172 + R172) = R10 296 for the 2015 tax year. This is not a deduction (it's not reducing taxable income); it's a tax credit. So it takes place right near the end of the tax calculation at the same time that you are credited with any tax already paid in the form of PAYE or provisional tax.

Medical costs that your medical aid does not cover can potentially also reduce your tax obligation, but these uncovered medical costs need to be quite big relative to your income to even make a small difference. Nevertheless, keep a record of all uncovered medical expenses and enter the total into the appropriate place in your tax return. Taking photographs of all receipts and storing them digitally is probably the best approach.

For more information see Medical scheme fees tax credit (SARS) and Claiming medical expenses (SARS).

Tax free savings accounts

These were introduced for the first time in the 2015/2016 tax year (the tax year that we are currently in and not the tax year for which we are about to start submitting our tax returns). So there is still time to get one of these, but knowing exactly where to get it and what you should include in it will take some research - this will be the subject of a future post.

Play by the rules

You are allowed to structure your investments in a tax efficient manner. This might influence decisions about:

• When you sell an asset (in which tax year) or how much of an asset you sell.
• How you structure donations (how much, who in a couple does the donating: hint, it's the person in the higher tax bracket!)
• If you're part of a couple, how you might choose who takes on additional work.
• If additional work is even worth it (if most of it sits in a higher tax bracket then it become less worth it; this is where knowing your marginal rate is helpful)

However, tax evasion is not cool and is not legal. Everything you submit must be an honest and accurate reflection of your various income streams. Know the rules so that you can play the game well within the rules.

If  you follow this link you'll come across a spreadsheet that you can copy and adapt to perform your own tax calculations. Some notes on using this spreadsheet:

1. It's designed for someone who knows the very basics of working in Excel.
2. I tried to make it as general as possible, but it is impossible to take everyone's possible tax situation into account. You may need to adapt it in some or all of the following ways:
• Take your age into account when it comes to the rebates and the exemption on interest earned.
• Work out your tax bracket for a given tax year when working out your "tax obligation for the year".
• Add more rows if you have more sources of income not listed.
• Remove the rows associated with retirement funding income and pension fund deductions of you are self employed or your employer does not offer a pension.
3. There may be some small discrepancies between your tax assessment as issued by SARS (the ITA34) and the result from this spreadsheet - if it differs by a few cents it's because you only enter whole number amounts in your tax return.
4. I'm only human - there may be some mistakes here. Let me know if you find them and I'll correct them - I'll update the tax calculator as any discrepancies arise.

Until next time, and good luck with e-filing tomorrow! (Yes, I'm assuming you'll do it the day it opens, not the day it's due! If you qualify for a tax refund you want to use it as fuel for your Financial Independence Engine as soon as possible!)

Tax in South Africa 101

Tax season for the 2014/2015 tax year starts on 1 July for individuals so I thought this would be a good time to start a mini series on tax. This post will start with a basic introduction and in the next post we'll go into some more detail.

Tax years for individuals always run from 1 March to 28 (or 29) February. It's historical. From 1 July you'll be able to submit your tax return for the tax year starting 1 March 2014 and which ended on 28 February 2015. Because tax years do not coincide with calendar years there is always a little ambiguity which is why talking about the 2014/2015 tax year is helpful terminology.

Tax is not scary. It's just like a friendly green button waiting to be pressed.
But you really should know what that button does.
Photo credit www.gotcredit.com (CC-BY 2.0)

Tax is Not Scary

Firstly, tax is nothing to be worried about. It's quite logical and straightforward once you're used to it. In addition to not being worried about tax, you should also not feel sad about paying tax. The money that we contribute to the government in the form of tax goes towards education (and paying my wife's salary!), healthcare, improvements to roads, parks and libraries. Yes, there is corruption. Yes, some of our tax is wasted and not spent wisely or efficiently. But on the whole, things function and they are only able to function because of the money that we contribute.

We pay various types of tax, but the two main types of tax that we experience are tax based on our spending in the form of Value Added Tax (VAT) which is 14% as well as tax based on our income. Income tax is based on a percentage of the total income that you earn after subtracting allowed deductions.

Main types of income subject to tax

• employment income (salaries and wages)

• employment bonuses

• employment fringe benefits (housing allowance, medical aid contribution etc.)

• interest earned (on savings accounts, fixed deposits, from money market etc.)

• dividends (regular payments from companies of which you are a shareholder)

• capital gains (profit on the sale of an asset)

Main types of deductions allowed

• retirement vehicles: pension funds, retirement annuities, provident funds
• we'll go into the exact rules in the next post

• donations to the right type of organisation (up to 10% of taxable income)

• medical tax credits (based on contributing to a medical aid)
• the exact details will come in the next post

The Tax Calculation

Once you've added in all the income that is subject to tax and deducted all the allowed deductions you are left with something called your taxable income. 

A percentage of this value is calculated as your tax obligation for a given tax year. There are six tax brackets and the bracket that you fall into depends on the size of your taxable income (i.e. income after allowed deductions). For 2014/2015 the the tax brackets work as follows:

1. Any taxable income less than or equal to R174 550 is taxed at 18%.
2. Anything between R174 550 and R272 700 is taxed at 25%.
3. Anything between R272 700 and R377 450 is taxed at 30%.
4. Anything between R377 450 and R528 000 is taxed at 35%.
5. Anything between R528 000 and R673 100 is taxed at 38%.
6. Any portion of taxable income over R673 000 is taxed at 40%.

The rate associated with the tax bracket that you fall into is known as your marginal rate. If you lie in a higher tax bracket then any portion of your taxable income that falls into a lower tax bracket is taxed at the rate of that bracket. The calculation looks something like this:

Everyone also receives a tax rebate which is deducted from this tax obligation. For 2014/2015 the rebates are R12 726, plus another R7 110 if you are older than 65 plus another R2 367 if you are older than 75. 

If you're employed, your employer should be taking off tax every month in the form of Pay As You Earn (PAYE). If you're self employed you are classed as a provisional tax payer and provisional tax needs to be paid part way through the tax year. In either case, you can subtract from your tax obligation any tax that you have already paid to work out how much tax you still need to pay or how much of a refund you will receive if you have paid "too much tax".

Don't panic if you found any of this confusing! Next post we'll look at some example tax calculations and I'll also share a spreadsheet that can help you with the calculations. But I think it's important to see the maths behind the tax calculations.

Hold on to any questions you may have until the next post - then if you still have questions fire away!

Useful South African Revenue Services (SARS) references:

• Taxation in South Africa 2014/2015
• Rates of Tax for Individuals

The Grace of Giving: Now or Later?

John Wesley famously said, “Earn all you can, give all you can, save all you can”. Most of us will admit that generous giving is an admirable quality. How does this fit in with the quest for financial independence?

Now or Later?

As always, there are several sides to the argument...
Photo credit: Kristofher Muñoz (CC-BY 2.0)

At the moment, as an example, we live on roughly 22% of our joint salaries (post tax). Surely that leaves 78% to donate to charities and organisations that desperately need financial support? John Wesley also said “Do you not know that God entrusted you with that money (all above what buys necessities for your families) to feed the hungry, to clothe the naked, to help the stranger, the widow, the fatherless; and, indeed, as far as it will go, to relieve the wants of all mankind?" Whether or not you believe in God, the needs in this country are so enormous that it is difficult to sanction holding on to resources which could serve others. 

On the other hand, if we are particularly good stewards of our wealth, then surely it is better for us to take good care of it, ensuring optimal growth, and allowing much greater generosity in the future - putting compound interest to work for charity, as it were. The hope is that after reaching financial independence, our ability to be lavish with our giving will be much larger. Besides, if we don't save at all, we ourselves will be a burden on society at some point in the future when we are no longer able to work. 

And if we can imagine a third, less altruistic hand in this argument, what about the whole point of this blog? Aren't we supposed to be saving everything we possibly can so that we can reach financial independence as quickly as possible? That couple of thousand rand that you give away each month could be powering the financial independence engine and shaving months if not years off your working life. 

Since this one is probably a bit easier to answer, let's put it to rest now:

Reasons to Give Now:

1. Gratitude. Giving really is a grace. It gives me a chance to reflect on everything we've been given. How wonderful that we are in a position to have so much more than we need that we can give money away! How wonderful that we are able to touch the lives of others, even in a small way. How wonderful that we are able to encourage and support causes that we believe in.
2. There are an awful lot of needs right now. Telling the NGO to let the children in the orphanage hang on a few years for their supper because we're just letting their donation grow by compound interest... you can imagine how well that wouldn't go down. The church roof might actually fall in by the time we are good and ready to start giving. 
3. Good habits die hard. Even if you are giving less than you plan to give in the long run, it means it won't come as such a shock when you finally reach the point where you want to start giving a significantly. The danger of course is that we get so attached to our money that by the time we were going to start, it's just too much... or we haven't taken account of it in our FI calculations, or, or, or... Far better to put the habits into place from the beginning, even if it burns a little bit.
4. Tax. You won't ever make money by giving but if you're giving to the right types of organisations (section 18A) then the government will give you a tax rebate on some of your donations. Up to 10% of your taxable income can be deducted from your taxable income via donations. So you pay a bit less tax. (Mr Cent(ri)frugal will do a more detailed post on this later - this is called delegation.) What is comes down to as far as I'm concerned is you're forcing the government to donate money to the charity of your choice. I like. 
5. Giving in other ways. This doesn't really belong on this list, but it is still something to consider. Sometimes, we can (and should) be giving acts of service, not only money. This costs nothing but time, but can be hugely valuable. Does the organisation you're supporting need volunteers? Maybe this is a way that you can maximise both giving and saving. (I still don't think financial giving should be off the table, though...)

How much then?

Not whether there should be a gift, but what size the gift should be.
Photo credit: FutUndBeidl (CC-BY 2.0)

Okay, so assuming that you agree with me that a certain amount of giving should happen now, the question really comes down to this: where is the balance between the "give all you can" and the "save all you can" clauses of the Wesleyan advice with which I started this post?

I think this is really something each individual or family needs to figure out for themselves. I'll share our thinking, not because I think we've necessarily got this sorted, or because we feel grandly self-righteous about how much we give (as you'll see, we haven't reached our giving goal yet), but because it can be helpful to have a benchmark; somewhere to start your own thinking.

I mentioned that we live on approximately 22% of our post tax income. We donate about 8% of that income to two organisations - one religious, one education NGO. The remaining 70% goes to savings. 

Our end goal is to be giving the same amount that we live on. Wouldn't it be wonderful if we could each support another family to the same standard of living that we enjoy? Of course this money wouldn't go to one other family, but would be spread out across the organizations that we support. It simply gives us an image of how we would like the world to be: every person fully supporting one other person.

We haven't reached this giving goal yet. At the moment, it would just put our financial independence goal too far away. We are (theoretically) only supporting just over one third (8/22) of another couple, living at the same level as we do. But we're working on it. And after financial independence we are confident that this will be possible, if not exactly easy. It forms part of our plan: we are saving more now, aiming for a bigger goal, so that we can make it happen in the future.

In closing, I really do believe that giving, both now and later, is an incredible opportunity. It puts you at the forefront of a different way of seeing the world; a way of seeing the world that isn't about "us" and "them" but only about all of us, together, doing the best we can. Even if we don't get it right straight away, it is a dream that we can all work towards, starting with the smallest donation and building up from there.

To gracious giving, and generosity of heart!
jjdaydream

Cycling

Hi again everyone

People tend to look at me  bit strangely when I tell them that I cycle to work. I must say that I had a lot of misgivings at first too. But now I think that ditching the car (most of the time) has been one of the best changes we've made to our lives in the last few years. Here's my bold summary:

You should cycle to work.

Who wouldn't want to ride a bike when it looked like this?
Photo credit: Michael (CC-BY 2.0)

  Not sold? Not even by the blue and yellow bike?

Benefits of cycling:

1. The Planet. People, we do not live on an infinite resource. I would like my children to know what trees look like from first hand experience. Every kilometer cycled is a kilometer less fossil fuel consumption.
2. Your wallet. Our very basic little citiGolf costs approximately R4 per kilometer, if you factor in wear and tear, maintenance, depreciation and fuel (which you absolutely should, by the way. That new clutch is not going to pay for itself!). How much does your car cost? Go here to get an estimate. It totally changed my perspective when I worked out that my home-work route was costing me R50 a time. Would I really spend R250 per week just getting to work?
3. Health. I am fitter (and skinnier) than I've ever been in my life, despite eating like a Trojan. This comes down to simple Maths: although I don't cycle fast, or particularly far, I get about an hour's worth of exercise on average five times a week. This makes a big difference to a totally non-gym girl. If I don't cycle for a week, I can feel the stress levels rising as well. Apparently endorphins are a real thing.
4. Connection. Moving more slowly, and not isolated in your car bubble, you notice more. This week, I noticed that the pavements near our house had been swept, and spent several moments feeling grateful to whomever had toiled at that thankless task. I shared a wry grin with some domestic workers setting off on their longer journey home. Cycling gives me a chance to connect with the world around me far more than driving.

Being connected to the world around you: priceless.
Photo credit: Dustin Gaffke (CC-BY 2.0)

Problems with cycling (and how to make them go away):

1. "I'll arrive at work all sweaty and gross". Actually, you don't get that hot and sweaty, even in summer: cycling works up a pleasant breeze. You also don't have to cycle as if you're about to win the Tour de France. I usually take it easy; and if I can feel that I'm getting a bit warm then I deliberately slow down for the last few minutes of my trip. 
2. "I can't work in cycling clothes". Um, most workplaces have bathrooms, right? Some even have shower facilities. Now since I'm a teacher and I am NOT sharing a shower facility with the kids (we all have limits), I don't shower after my trip. But I do keep my work clothes in my staff locker and change when I get to school. I transport a week's worth of clothes when I drive in on the day I stay for evening classes. The quick-change process takes about 5-10 minutes in the morning.
3. "It's too far". If you live less than 10 km from work, just stop being a wuss. If I can get fit enough, trust me, anyone can. If you live further away, consider moving closer to work, or moving work closer to home: quickest way to reduce your carbon footprint too!
4. "It's cold and wet in winter". See point three above. The benefits far outweigh this consideration, unless it is actually POURING when you want to leave. And that has only happened to us once or twice this whole winter so far; it is far rarer than you might think. If you ain't already sick, you'll dry and warm up in no time. 



It isn't snowing, so stop making excuses!
Photo credit: Sakeeb Sabakka (CC-BY 2.0)

5. "I've got too much to carry". Easy. Stay at work a bit longer. Work a bit more efficiently. Leave work at work. This is a fantastic side effect of cycling. Brain space expansion!
6. "It'll take too long". It takes me about 30 minutes to cycle to school. If there is absolutely no traffic (i.e. almost never) it take 15 minutes to drive the same distance. And I'm getting in my free gym and mental health session as well. The time investment might feel like a lot, but it is actually minimal, considering the other benefits. I do leave a little earlier in case of flat tyres and other cycling catastrophes but that just gives me a bit more time at work to get my ducks in a row. My husband sometimes beats his colleagues home, as he almost always cycles during peak traffic.
7. "It's not safe". the received wisdom in South Africa is that the streets are a mad, bad place to be, especially for women, and much better only seen from the tinted windows of your vehicle. This is an important one to get right: it isn't worth risking your personal safety. BUT if you think about it, the very act of living risks your personal safety. You have to decide what risks are acceptable, based on their reward. My safety boundaries? I won't cycle at night. I have chosen my route based on the cycle paths as far as possible. I try to cycle with my husband through the dangerous/dark parts of the trip. I am hyper cautious on the road, and often wait for ages at intersections rather than take any chances. Depending on where you live, this last point might be the deal breaker. But think carefully before you allow it to put you off: you may just be making excuses. Plus, the more cyclists we have on the roads, the safer it will be for everyone: more cycle paths, better motorist awareness, general goodness.

So, to return to my first point... You should cycle to work.

It's okay to be scared - I was at first! Don't let fear stop you.

It's okay to start out slow. I'll post another time on how I got into the swing of it. Don't let inertia stop you. 

It's also okay to wimp out once in a while. Every day that you don't drive is benefiting you in so many ways. Don't let a desire for 100% perfection stop you.

Basically, don't let anything stop you.

To freedom!

jjdaydream

The Beast of the Night called Debt

EMERGENCY POST!

While cycling to work this week I saw a newspaper headline telling me that South Africa is "the world's most indebted nation". I was going to post something about where to bank or where to invest in South Africa this weekend, but debt is such a serious emergency that this post cannot wait any longer!

The Beast of the Night Called Debt
Photo credit Pablo Piedra (CC-BY 2.0)

To see why debt is such a terrible thing. Let's take a look another look at the formula that tells us how how our investments grow with compound interest:

which we can compare to the formula that tells us how our debt grows:

See any difference? You shouldn't, because they're the same. That's right, the same power of compound interest that can help you buy freedom when you invest, acts against you when you're in debt.

When you have an investment it grows exponentially and when you have a debt it also grows exponentially - according to the same laws of mathematics. It is said that "Those who understand compound interest, earn it. Those who don't, pay it." My true hope is that you will come to truly understand compound interest. If you can't wait for what I plan to write in a future post - begin your studies here and work your way up.

The current prime lending rate in South Africa is 9,25%. Credit card rates are anywhere between 14% and 23%. Borrowing money at any of these rates can only lead to real financial difficulties. If we take inflation into account, then the prime lending rate is effectively about 4,25% and credit cards are between 9% and 18%. If you have any debt at these rates, then paying off this debt gives you a guaranteed real return (above inflation) equal to that rate. So paying off debt fast and aggressively is the wisest thing you could do.

Good debt? Rare and risky if it exists.

People often talk about "good debt". I'm not going to completely refute this idea, but I do feel the need to highlight the only conditions under which debt can be "good":

1. The interest rate that gets paid on the debt is low. This automatically excludes all credit cards as well as borrowing money for a car. Oh, and buying anything on hire purchase is a seriously bad idea.
2. The borrowed money is being put to good use. This means that you're not borrowing money for general life expenses or leisure expenses. Putting the borrowed money to use means you're using it to earn more money (a concept referred to as leveraging). This can definitely be profitable, but you really need to know what you're doing. The borrowed money could be to start a business or to inject additional capital into an existing business.

Personally, I don't like debt at all. I believe that you should up for anything you want to buy with cash. Yes, even a house. But I do acknowledge that money might need to be borrowed in order to produce an income with which to do the saving (as in the business example above).

So credit cards... what role do they play in our quest for financial freedom? Firstly,

Credit cards are not for borrowing money. 

They are for managing your cash flow better. Most credit cards in South Africa give you about 55 days interest free (the actual number of days is not important, only that it is more than one month). This means that when you use your credit card to buy your groceries and pay for strictly necessary expenses the actual cash you have earmarked for these expenses sits in your bank account earning interest! As long as you pay your credit card in full, every month, then you will never pay interest. This is the only way to use a credit card! Never pay only the minimum amount due (it's a trap!). Never let a month go buy without paying the full amount owing. If you don't have the self discipline to do this then you should not have a credit card.

We aren't fortunate enough in South Africa to have the types of credit card rewards programmes that they have in the US. So we might not be able to actually earn money from credit cards, but we can shop around and choose a card that will cost us the least.

The best card that I could find is from Virgin Money - there are no monthly, yearly or admin fees. Internet banking with this card is free. They do have some other rewards, but none of them are really relevant to our family's needs.

I'll do another post on the rewards programmes that we do have in South Africa, but in the meantime I'll share my conclusion: they're not worth it. Now this conclusion depends on your individual spending patterns and circumstances so you will have to do your own calculations, but in most cases the rewards escalate with spending. If you're planning on living a frugal lifestyle to generate fuel for your financial independence engine then rewards programmes won't benefit you because the very thing they reward is consumption.

For more takes on just how serious debt is, let me point you towards Mr Money Mustache who tells us that "debt is an emergency" and jlcollinsnh who says that "debt is an unacceptable burden".

So to summarise:

1. Don't get into debt in the first place.
2. If you already have debt, pay it off as fast as possible.
3. Use credit cards wisely and not for their advertised purpose.

Now go forth and defeat the Beast of the Night called Debt!

Pillar 2: The Financial Independence Engine

Pillar 2: The Financial Independence Engine

(aka sensible investments)

Recall that the second pillar upon which a financially independent life is based is choosing sensible investments which will grow faster than inflation. You need to choose investments that give the biggest possible rate of growth (i in the compound interest formula). In this post I hope to give some background to the options available to you.

Our Financial Independence Engine. Next stop, "Freedom!" Choo Tjoe!
Photo credit State Library of Queensland (no known copyright restrictions)

Saving vs Investing

Firstly, it's important to make a distinction between saving and investing.

Saving is a verb - it's what we do as we build up Pillar 1. We live a frugal lifestyle and the money that we're no longer spending on things we don't need we save. But once the money has been saved it has to be put somewhere.

Savings is a noun - it refers to our saved up cash.

Cash in a treasure chest may look pretty, but it's the Engine we are looking for.
Photo credit Tom Garnett (CC-BY 2.0)

 Now cash doesn't necessarily mean actual coins and notes. It can refer to something like a bank account, a fixed deposit or a money market fund: where your money is somewhere invested in actual coins and notes, and (some) of the interest on that is passed on to you. This is what we call a cash investment.  The thing about all of these cash investments is that they won't be working hard in the way that you need them to in order to build up Pillar 2. Even when you're earning interest on your cash (alarmingly NOT always the case in South African banks), this interest is usually in line with or lower than inflation.

Cash is not King
Cash is a Lazy Prince who is vulnerable to the Vampire of Inflation

Inflation is a Scary Vampire, but there is a way out!
Photo credit Enokson (CC-BY 2.0)

At some point I'll do a post all about inflation. For the moment, all you need to appreciate is that inflation is the rising price of goods and services as time progresses. Inflation is the reason that prices go up and why salaries need to have "cost of living" increases. Inflation has hovered around 6% in South Africa for the past few years and at the moment it's about 4,5% - so let's just simplify things and say we're dealing with an inflation rate of 5% (to see historic inflation rates click here). Now not all goods and services rise with inflation - some rise faster and some rise slower. But it's a good way to estimate the price you can expect to pay for something from one year to the next - something that costs R100 today will probably cost about R105 next year.

The problem, of course, is that although your cash is growing (hopefully) it isn't necessarily growing fast enough to counteract the effects of inflation. If you earn R3 in interest but the price of your groceries went up by R5, you've actually lost R2; even though you might have thought that your savings was growing!

If you are getting 3% in interest (since we're hoping to be earning on significantly more than R100), that isn't good enough - over the course of a year your savings will still get effectively smaller by 2%. Do this every year for 10 years? You've lost a lot of money. It's still more actual rands than you started with, but it can't even buy the same amount as you could at the beginning. You are further from financial freedom than ever.

If you don't want to lose out to inflation then you're left with a few options:

1. Spend your money now before the Vampire of Inflation sucks its value dry.
2. Invest your money in something that grows at the same rate of inflation.
3. Invest your money in something that grows faster than inflation. 

The first option seems attractive - spend now before prices go up next week. Logical, right? But with this approach all we're doing is spending, not saving. We'll never have our money working for us and growing with compound interest because we'll never have any money. So let's scrap this option immediately. It goes against Pillar 1 because it will leave us with no fuel for our financial independence engine (Pillar 2).

And who would choose the second option if they could choose the third option? So let's see how to achieve growth faster than inflation.

We need to save money and then once we've saved it we need to put it into a suitable investment. So far we've determined that this suitable investment is not cash under the mattress, a bank account, a fixed deposit or money market. So what's left?

The Stock Market

All evidence spells out "Stock Market" as our Engine of choice
Photo credit Simon Cunningham (CC-BY 2.0)

It's by investing in companies listed on the stock market that we'll get the inflation-beating returns we're looking for. But wait, aren't stocks "risky"? The short answer is No. The longer answer needs us to define what we mean by "risk". In the world of investing, risk is related to the probability that your investment will lose value. Okay, we probably agree on that definition. But how can I say that the stock market is not risky if a company that you're invested in can go bust and lose it's entire value?

Let's be clear at this point. It is entirely possible to lose money in the stock market if you invest in any of the following ways:

1. Investing for the short term. Investing now and expecting to cash in on your investment within a very short time period. At any particular moment your investment might experience a temporary (but possibly very large) dip in value despite the fact that it is growing overall. You don't want to be forced to withdraw it during the dip.
2. Investing in a small number of companies and tying the fate of your investment to those few companies. Those companies might die a horrible death, in which case your investment has gone down the tubes. Don't invest in a company based on "a hot tip" from a friend or because the media is going crazy about it.
3. Trying to time the market by "buying low and selling high". This is a nice idea in principle, but it's impossible to consistently get this timing right. Regular people are not soothsayers or stock market geniuses.

So how do we invest in the stock market and reduce the above risk?

1. Invest for the long term - minimum 10 years.
2. Invest in a large number of companies - this is called diversification. If one company goes bust you still have money in all the other companies working for you.
3. Don't try to time the market. Invest regularly and consistently. It's not about timing the market, it's about time in the market.

At this point I think it's really important that you get a decent level of understanding of the stock market before you start investing. One of the Overseas Masters, jlcollinsnh, has done a wonderfully readable explanation of investing in the stock market. He writes from the perspective of the US stock market, but most of what he says can be applied to the South African stock market as well.

We're nearly at the point where we can start looking at specific places to invest your money in South Africa. But it really is important for you to feel comfortable and confident when it comes to investing the money that you have saved through Pillar 1 - this is why all this background has had to come before the specifics.

Until next time!

Living without Want: Cancelling Discretionary Spending

Hello fellow sojourners!

I'm not financially minded. Accounting, tax returns and spreadsheets leave me stone cold. So I'm here to speak about the more personal/day-to-day side of our financial independence journey.

Not being quite as hardcore as my husband (Mr Cent(ri)frugal to you) I found it difficult to adjust to the mindset required for financial freedom. I was never exactly a spendthrift - I grew up on a tight budget, and chose teaching as a profession, so saving wisely and spending carefully were always part of my outlook. FIRE was a reasonably natural extension of my natural inclinations. 

The Discretionary Spending Trap

However, when I started working, having the ability to randomly decide to go out for coffee with a friend, purchase a jersey that caught my eye or buy a treat at the grocery store without counting the metaphorical pennies was a wonderful side-effect of a grueling job. Having my R200 (or whatever it was) of "free" spending money each month made me feel... free. If I wanted it, within reason, I could have it. And who doesn't like that? And if the budget got a bit expanded occasionally, well, where's the harm in that, right?

So the notion of cancelling discretionary spending was quite a stretch.

Photo credit: Robert Couse-Baker CC-BY 2.0

However, as everyone knows, stretching is actually a good thing. Especially when it gets you out of a particularly insidious mind-trap. Here are some of the questions that helped me to adjust to a new way of thinking:

Do I need it?

If you are a middle class person, the answer is probably: No. Which is sad when your credit card is itching, but not really sad when you think about all the people - some a few minutes drive away from you - who don't have food, water, sanitation or a roof over their heads.

So, 99% of the time, a few minutes honest reflection tells me... nope, I don't need it. I have eaten. I am warm and clothed. I have more than enough. This discretionary item is a want. It sounds so simple, but it's a good place to start your thinking.

What do I really want?

I was recently given a voucher for a large shopping mall. It is sitting in my bag, right now. Every now and again, I think about what I would like to spend it on. It's a fun activity, one which reminds me of the delicious planning and anticipation when I received money as a child. I used to save up to buy something, and I can still remember the feeling of walking to the shops with the correct sum in my pocket with a glorious glow of achievement.

But truthfully, once the coveted item was purchased it was often something of a let down. Of course, the glow of getting lasted a few days, but the toy or clothing item, whatever it was, was never quite as exciting. After a week or two, it was often relegated to the shelf of "not quite favourites".

So what was it that I really wanted?

The same is often true of "event" spending - dinner, coffee, movies with friends. Whether it is R50, R100, R200 or R300 later, I've had a lovely time. My relationships have benefited, I feel relaxed and happy: good spending, right?

Well, maybe. But what, exactly, is it that made me happy? Was it the conversation? Because that is free. Was it the coffee? Because that costs a lot less to make at home. Was it the movie? Cheaper to rent, and probably nicer because you can pause to go to the loo or get a snack any time you like; plus there are no annoying people with glowing phone screens. Was it the popcorn? Have you tasted homemade popcorn?

As for restaurant food, yes, sometimes it is way better than anything I can make at home. But sometimes it's pretty mediocre, and I spend the evening with menu envy, looking at the dish at the next door table. Sometimes I eat too much, or the waiter takes ages, or parking ends up costing a fortune. Wouldn't a special meal, carefully made at home, properly presented for once, give more enjoyment, show more love, result in more relationship building?

Again, what is it that I wanted? Really wanted?

Photo credit: Charlie Foster (Public Domain)

In most cases, the thing that truly makes me happy is free. Or at least costs a lot less than commercialism would lead me to believe - don't get me started on advertising! Many friends have been more than accommodating, and in fact sometimes relieved (because loads of people are really on something of a shoestring budget, one way or another) when I've said "What about..." or "I would rather..." or "I'm on a tight budget, so...". Sometimes, this opening leads to a candid and up-building conversation that wouldn't have otherwise been possible.

So what is it that you want? And is swiping that card going to buy it for you?

Is this an exception?

As with every system, it would be naive to think that there are no exceptions. Sometimes, there is a birthday party, a new friend, a big celebration or some other reason to break every rule in the book. 

Maybe not every rule.

We still go out to dinner, or get takeaways - just once every couple of months, instead of once a week. And we find that those occasional outings become just that: occasions, rather than run of the mill, expensive habits. I'll write another post sometime on how we save money even on special occasions - without diminishing enjoyment. For now, suffice it to say that sometimes it's fine to spend money on important things. 

Also, sometimes you've just had a "&^#&-off" kind of day, and eating a R5 chocolate-bar is just going to make you feel momentarily better... and sometimes that's fine. Especially if it's a R5 chocolate-bar instead of a R200 massage. And again, if it isn't a weekly habit, but a once-in-a-while treat. Which will also make that little treat a lot more... treaty. 

Living without Want

So, to return to that voucher sitting patiently in my backpack... it isn't burning a hole in my proverbial pocket, as it definitely would have been a few years ago. I've thought of one or two useful and fun things I could spend it on; and we might even treat ourselves to a burger at the same time. It'll be an event, spending that voucher, and it isn't even that much money. In the meantime, my life goes on, with all it's ordinary enjoyments and non-money-related pleasures.

I still want things; everyone does. But your life can be fully satisfying without spending money on a whim. Your desires are not the boss: you are. Don't let your "wants" rule you.

Yours in the fullness of life,

jjdaydream