Understanding how tax works

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If you have a job, a large portion of your income will go to the government in form of taxes. When you get your salary, it will get taxed. If you visit your grocery store, you will get taxed again. The income that you get from your investments is taxed again. When you use International flights, you also pay tax. Understanding how tax works is very important – this will help you to make informed decisions.

Additional Articles:

• Think beyond income and expenses.
• Saving or Investing for your retirement – what are the options?

In this article we will show you a very simple scenario of how to calculate the tax on your personal finances. We will also show you that investing can make you pay less tax than spending money.

Calculating Income Tax

The following extracts are from the South African Revenue Services (SARS):

Suppose the following holds:

• Gross Salary per month is R 20 000
• Provident/Pension of R 1000
• Travel Allowance of R 1 000

Therefore your taxable income is a follows:

• Taxable Income = Gross Salary – Provident Fund – 20% of Travel Allowances

This gives us:

• Taxable Income = R 20 000 – R 1 000 – 0.2 x (R 1 000) = R 18 800

The yearly taxable income is R 225 600 and this belongs to the tax bracket { R 205 901 to R 321 600}. The amount of tax that you are going to be charged (also called Pay As You Earn or simply PAYE) is as follows:

• Taxable Income exceeding R 205 900 = R 225 600 – R 205 900 = R 19 700
• Total Yearly Tax Before Deducting Tax Rebate = R 37 062 + 0.26 x R 19 700 = R 42 184
• Total Yearly Tax After Deducting Tax Rebate = R 42 184 – R 14 958 = R 27 226
• Monthly PAYE = R 27 226 / 12 = R 2 268.83

Therefore you will get a deduction of R 2 268.83 from your monthly salary. On top of that, you also need to pay a premium that goes into Unemployment Insurance Fund (UIF). UIF will be the lesser of R 148.72 per month or 1% of your gross income.

• UIF = min {0.01 x R 20 000 ; R 148.72} = min { R 200; R 148.72} = R 148.72

. Your take home salary will be:

• Net Salary = Gross Salary – Provident Fund – PAYE – UIF
• Net Salary = R 20 000 – R 1 000 – R 2 268.83 – R 148.72 = R 16 582.45

Who pays more tax?

Let us consider two people:

• Person A spends all his money.
• Person B saves R 1500 per month, Invests R 1500 per month in dividend paying stocks and spends the remaining balance of his Net Salary.

Suppose the following holds:

• Interest rate on savings account is 5% per year compounded monthly.
• Dividend Withholding tax is 20%.
• Dividends are payable once a year.
• Value Added Tax is 15%.
• The average cost of a share is R 100.
• Dividends are declared to be R 1.50 per share.

The table below shows the tax exemptions for interest income:

Person A

• Income tax ( Tax on Salary+ UIF) = R 2 268.83 + R 148.72 = R 2 417.55
• VAT = 0.15 x Net Salary = 0.15 x R 16 582.45 = R 2 487.37
• Total Tax Payable (Inclusive of UIF) = R 4 904.92

The total tax per year for Person A is R 58 859.01. This is equivalent to approximately 25% of the Gross Salary.

Person B

• Income Tax (Tax on Salary) = R 2 417.55
• VAT = 0.15 x (Net Salary – Investments & Savings) = 0.15 x (R 16 582.45 – R 3 000) = R 2 037.37
• Total Shares purchased per year = (R 1500/R 100) x 12 = 180
• Dividends received = R 1.50 x 180 = R 270
• Total Dividend Withholding Tax per year = 0.2 x R 270 = R 54
• Savings Balance per year (inclusive of interest) = R 18 418.28
• Total interest earned per year = R 18 418.28 – 1500 x 12 = R 418.28
• Tax payable on interest income = R 0 (since the total interest earned per year is less than R 23 800)
• Total Tax Payable per year = (R 2 417.55 + R 2 037.37) x 12 + R 54 +R 0 = R 53 513.04

Therefore, Person B pays R 53 513.04 per year. This translate to 22% of the Gross Income inclusive of interest and dividends income.

Therefore it can be noted that Person A pays more tax in a year than Person B. If a person invests a portion of his/her net salary, it will gain more income. You are taxed more if you spend the money since the VAT will be included in the prices of the products you buy.

Conclusion

Tax constitutes a large portion of a person’s salary in form of income tax, VAT and many other forms of tax. If you spend all your salary, you will be taxed more than someone who is saving and investing another portion of his/her income. Understanding how tax works can motivate us to invest more. You can also invest your money in a tax free account to reduce the overall tax payable in a year.