Types of investment growth

A few months ago my wife asked me to explain to her the difference between interest, dividends and capital appreciation. If we add in income then these are essentially the different ways in which money in an investment can grow. I'll admit that up until now I've probably been a little vague about the distinction between these different mechanisms of growth so I'll try to rectify that in this post. 

In the long run, all these forms of growth kind of end up doing the same thing - they all grow your money. And if we draw graphs of investments that experience these different mechanisms of growth then the graphs would look exponential:

These are the same graphs that are produced by the "compound interest" formula that we looked at in an earlier post. 

All types of growth can look a lot like a lot like compound interest and they behave a lot like compound interest as well. Money grows at a certain rate per year and in subsequent years you get growth on growth. Compound interest is just a specific type of compound growth.

So if everything kind of looks the same and does the same thing then why is it important to make the distinction between these different mechanisms of growth? Why don't we just call everything interest and be done with it? Two reasons:

1. The "rates of growth" typically associated with each mechanism of growth can be very different. So some mechanisms will act faster on your money than others.
2. The different growth mechanisms are taxed differently. You need to know how they are taxed so that (a) you can invest in a tax-efficient manner and (b) you know how and where to declare the proceeds of your different investment growth mechanisms (the return on your investment) in your annual tax return.

These growth mechanisms are what cause the Financial Independence Engine to run and they cause it to run in slightly different ways.

Without further delay let's develop a rather silly analogy that will serve to illustrate the distinction between the different mechanisms of growth.

Edgar is the owner of a bakery that specialises in baking with interesting varieties and sizes of eggs - quail (small), duck (medium) and ostrich (large!). 

Photos used in the above image (left to right) credited to:
Roberto Verzo, snowpea&bokchoi and Beck (all CC-BY 2.0).

When Edgar does a stock take to see if he has enough eggs to cater for a large retirement party he doesn't worry about how many of each type of egg he has - he is only concerned about the total amount of eggy goodness he has (the rich golden yolk in particular). Quail eggs are the smallest with less yolk per egg, next come duck eggs and lastly the ostrich eggs with lots of yolk per egg.

In our analogy, the amount of eggy goodness or the yolk represents the rand and cents value of our investment. The different types of egg represent a single "unit" of an investment - for example a "unit" in a unit trust, a single share in a company or a gift card.

Egg yolk is the currency in this eggsample :-)
Photo credit Emilian Robert Vicol (CC-BY 2.0)

Let's continue...

It turns out that Edgar has more than enough egg yolk for the retirement party that he needs to cater for. In fact, he has so much extra egg yolk he's able to lend it out (in the form of eggs) to some of his friends who are also in the exotic egg catering business. In return for lending out egg to his friends in need, they will return the amount of yolk that they borrowed plus they will give him some more (either in the form off egg yolk or in the form of eggs). Let's look at these different business dealings in turn.

Edgar earns interest from Alice
For every litre of egg yolk that Alice borrows from Edgar she promises to give him back the original amount of egg yolk plus 10% extra at the end of the year. On 1 January Alice borrows 20 litres of egg yolk. After a successful year in business Alice returns to Edgar on 31 December and gives Edgar 22 litres of egg yolk: 20 litres being the original amount borrowed and 2 litres (10% of 20 litres) being the interest. Edgar now has more egg yolk than he started the year with; his investment has grown.

Edgar receives dividends from Bob
Edgar thinks Bob's Egcellent Eggs, is a great company to invest in and he invests 100 duck eggs in Bob's company. When the company makes a profit, Bob likes to give all the profit to his shareholders - these company profits distributed to shareholders are called dividends. After a great year of business Bob pays Edgar a dividend of one litre of egg yolk. At this stage Edgar could take his egg yolk and make himself a decadent and fancy omelette. But seeing as he's not retired yet, Edgar does best to reinvest his dividends. One litre of egg yolk is roughly the amount of egg yolk in 10 duck eggs so Edgar gives Bob another 10 duck eggs bringing up the total of his investment to 110 duck eggs with a value of 11 litres of egg yolk. 

Edgar earns capital appreciation through Cathy
Edgar decides on a long term investment in Cathy's Egg Emporium. He lends her 10 duck egg in January 2000. Cathy is incredibly focused on growing her company. If the company makes any profits, she pours them straight back into the company instead of paying it to the shareholders. So although the shareholders don't get any benefit immediately, they own a share of something that is worth more and their investment has grown. In December 2024 Cathy gives Edgar 10 ostrich eggs. How many eggs did Edgar have in 2000? Ten. How many eggs does he have now? Ten. So Edgar has the same number of eggs, each egg is just worth a lot more (in terms of yolk). This is capital appreciation. With capital appreciation you own the same thing (such as a house) or the same number of things (such as shares in a company), but each thing you own is simply worth more.

Edgar earns (rental) income from Dave
Dave runs a fancy coffee shop frequented by tourists and he thinks having some ostrich eggs on display in the window would be just grand! 

Photo credit: Redmond (CC-BY 2.0)

He arranges with Edgar to rent 20 ostrich eggs, in return Dave will give Edgar 2 litres of egg yolk (from chicken eggs from the coffee shop kitchen) per year. Assuming that an ostrich egg holds 1 litre of egg yolk, Edgar has received a 10% return on investment (eggs with 20 litres of yolk rented out and returning 2 litres in rental income).

Cracking open the analogy

Interest and income
When your investment grows through interest you get more units, but each unit has the same value (each rand is worth one rand, but you have more of them). Interest gets paid to you regularly.

When your investment grows through income you also get more units and each unit has the same value. You also get paid regularly. So income can look a lot like interest. So what's the difference? Consider the example of Alice who paid interest on the borrowed egg yolk and Dave who rented the ostrich eggs from Edgar. The only difference is the form of the asset that was borrowed. Dave was borrowing something that was not egg yolk itself (ostrich eggs) but had a value in terms of egg yolk and he needed to pay rental to enjoy the privilege. Alice was borrowing a certain amount of yolk (which is equivalent to cash in this analogy) and she needed to pay interest for this privilege.

Dividends and capital appreciation
Bob and Cathy represent two extreme ends of the spectrum of how companies decide what to do with their profit. Many companies will pay some of the profits out as dividends to shareholders and retain some of the profits for furthering future growth. When Edgar earned dividends he earned it in the form of egg yolk (the cash currency in this analogy). He then had the option of keeping his dividends or reinvesting by buying more shares of Bob's company (measured in terms of duck eggs in this case). By reinvesting he increases the value of his investment because he has more shares, not because the shares he has are actually worth more. From Cathy, Edgar received no dividends and no intermediate payments. By retaining all the company's profits Cathy was making each share of Bob's more valuable. After 24 years Edgar's 10 eggs invested in Cathy's company were so valuable that he needed to receive ostrich eggs when we cashed in on his investment. In this example he had the same number of units of investment, but each one was worth more.

Remember that interest only barely keeps up with inflation (sometimes it doesn't even do that) so although it's useful it should not be your primary source of investment growth.

When you invest in companies through unit trusts, ETFs (Exchange Traded Funds) or actual shares you'll benefit from both dividend income as well as capital appreciation in the long term. Some companies pay out more dividends than others and there are unit trusts and ETFs that try to have a higher proportion of high dividend paying companies.

Rental income is useful (but see the tax implication below) and an easy way to have some exposure to it is through unit trusts or ETFs focussing on owning and renting property. You'll also get some capital appreciation through these unit trusts or ETFs as the values of the properties rise over time.

Tax implications

You can earn R23 800 worth of interest in a single tax year before you start paying tax on interest earned. You'll need to declare all interest earned from all your investments. You can get this amount by adding up all the amounts labelled "local interest" on the IT3(b) statements that you'll get from your financial management people and banks.

Dividends that you earn are taxed in the hands of the company before they are paid over to you. You'll need to declare all dividends earned in the "other non-taxable income" category on your tax return (and follow the same approach of adding up all the dividend amounts on your IT3(b) statements.

From year to year you'll probably not need to worry about tax on captial appreciation. This is because you'll only pay tax in the year that your investments are sold. This will (hopefully!) result in a large capital gain which follows the rules of Capital Gains Tax as described in the post on tax.

Investment income (such as rental income in the above example) is taxed in the exact same way as your regular income from your job. The full amount is included in your taxable income (no exemptions like interest income or the same benign treatment as capital gains tax)

A fifth way of growing your money!

The four mechanisms of growth that we've discussed so far are not the only ways to grow your investment. You can also manually put money in yourself! This is money that you have saved for the purposes of investment. It's the fuel required for the Financial Independence Engine before it starts running itself. 

In the short term, the amount that you are able to put in will far outstrip the investment returns from any of these types of growth. But eventually these growth mechanisms (the backbone behind Pillar Two) will start to earn more than you possibly can. The huge advantage of the investment growth mechanisms discussed in this post is that they are a type of passive income - meaning you don't have to work once they've started out earning you - this is the stage at which you've earned your financial independence.

The relationship between investing and borrowing

You might have noticed that depending on how you read the examples of Alice, Bob, Cathy and Dave they could sound a lot like credit and borrowing. Yikes! How did an example about an investment start to sound like an example about borrowing? Investing (or lending as in the example above) goes hand in hand with borrowing. When you invest in some investment product or company they are essentially borrowing money from you. From Edgar's perspective he's investing. From Alice's perspective, she's borrowing (as long as she's borrowing in order to expand her business, that's fine - as long as she doesn't start funding a decadent lifestyle on egg yolk credit!).

In a post that I hope to write soon we'll look at the different options of where to invest in South Africa. In the meantime I hope you've found this post useful!

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!)