Avoid Multiple-Income Tax Pain
29 February 2012
Posted by: Author: Steven Jones
Avoid Multiple-Income Tax Pain
Our "progressive” tax system has a regressive impact on your wallet if you have more than one income source
A favourite mantra of investment advisors is"diversification”, which is a fancy word for what your grandmother would call "not putting all your eggs in one basket”.Simply put,there are different types of investment markets (equities,property, bonds, cash, etc.) whose movement is driven by different factors, so in order to reduce one’s risk it is usually considered prudent to have a portion of your money invested in various different assets.
Most reasonably sophisticated people would understand the merits of diversifying their investments,but far less attention is given to diversifying one’s income.Yet having only one source of income is probably the greatest risk that (particularly) salary-earners face—it just takes one round of retrenchments to move your income from 100% to zero.
While the idea of diversifying one’s income conjures up images of a business on the side, often referred to somewhat disparagingly as "moonlighting”, the fact is that if you (for example) own rental properties or derive pensions from one or more RA funds in addition to your company pension, you will be deriving income from more than one source.
However, to quote contemporary gospel artist Michael W Smith’s Leesha, "into every life a little rain must fall”, and when it comes to multiple income sources, the rain comes in the form of tax.Even though I am now a full time Methodist minister, my background as an accountant results in people asking me to have a"quick squizz” at their tax affairs.
And more often than not, when they have multiple income sources, my response (in contrast to what I preach from my pulpit) is usually not received as "good news”.The reason for the inevitable tears that result is a consequence of the way our individual tax tables are structured. Unlike corporate tax, where income is taxed at a flat rate irrespective of the amount thereof, individuals pay tax according to the sliding scale on Page 4. This is known as a"progressive” tax system, i.e. the more you earn, the more you pay.
So where does the problem come in? Let’s take an example of a 70-year-old retiree from a reasonably senior corporate position, who receives a monthly pension of R20 000 from their pension fund, from which employees’ tax (PAYE) of R2 748.58 is deducted.This particular pensioner has no other source of income.Applying the tax tables, this pensioner will pay R32 983 on annual taxable income of R240 000.
Assuming no deductions, this pensioner will be in a "break-even”situation with SARS when completing their tax return, since the correct amount of tax has been deducted each month.Now let’s take the example of another 70-year-old retiree who worked for the same company in a similar position to the pensioner in our first example, except that in this instance our retiree chose to live more modestly, deciding to forego the fancy house and BMW and instead ploughing their spare cash into a retirement annuity (RA) each month.
Upon retirement, this pensioner receives R20 000 a month from their pension fund, and a further R20 000 a month from their RA investments.Both funds deduct PAYE from these annuity payments each month.At the end of the tax year, our retiree will have had the earnings and tax deductions for the year that appear in Table 1.
So far, so good. Both pensioners have had the correct amounts deducted from their monthly annuities. Both should therefore be in a break-even situation with SARS at the end of the year—right?Wrong! In fact, our second pensioner will end up with a tax shortfall of R47 517! But how is such a scenario possible? The answer is found in an examination of how the two pensioners’ respective tax positions are arrived at (see Table 2)."This is outrageous”, you may exclaim. "Surely it is the responsibility of the respective funds to ensure that the correct taxis deducted?”
The answer to this question is are sounding "yes”, but herein lies the rub—both funds have deducted the correct tax. Whenever an employer or fund calculates the amount of PAYE to be deducted and paid over to SARS each month,it does so on the assumption that the income earned is that particular taxpayer’s sole source of income.Because of the way the calculations are done on the payroll system, both funds (in this particular example) have not only taxed the income according to a lower tax scale, but have also both taken the primary and secondary rebates into account (a taxpayer can only claim these rebates once).
So how does a taxpayer avoid the shock of having suddenly to find nearly 48 grand to pay SARS at the end of the tax year?There’s no legal way (other than legitimate deductions) to avoid paying SARS what is owed, but there are two ways in which the blow can be softened.The one way is to instruct each fund to deduct an extra R2 000 a month in PAYE.
The other way (and in my opinion the preferred way) is to open a money market account and deposit R4 000 into it each month.This way, at least one can earn a bit of interest on the money set aside.Does this mean that one should forget about saving extra for one’s retirement? Not at all! For even though the second pensioner ends up with a much higher tax bill than the first, the second pensioner is still better off by R159 500 per annum compared to the first pensioner.And no pensioner I know has ever complained about having too much pension!
Source: By Steven Jones (Tax breaks)