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So you think you’re better off in a money market fund?

Don’t forget about the tax.

Over the last five years the poor performance of the local stock market has led many investors to consider moving away from equity unit trusts. Many have preferred the perceived security of money market funds, where returns have been higher.

Between 1 July 2014 and 30 June 2019, the money market delivered around 7% per year. According to figures from Morningstar, only four out of the 96 local equity funds with track records that long performed better than that. The average equity fund returned only 3.5% per year over this period.

At face value, it therefore would seem that the money market has obviously been the better place to be invested. Every money market fund in the country outperformed the average equity fund.

Things are not always what they seem

However, investors should be cautious about making simple comparisons when looking at returns from different asset classes. That is because the form of this growth is different, and therefore how it is taxed is different. And that can have a significant impact on returns.

All of the return from a money market fund is in the form of interest. After the initial exemption of R23 800 for anyone under the age of 65 or R34 500 for anyone older, this is fully taxable at normal income tax rates. That could be as high as 45% for those earning more than R1.5 million per year.

Growth in an equity fund, however, comes in two forms. The first is dividends, which are currently taxed at 20% in South Africa. The second is the increase in share prices, which is a capital gain. That attracts no tax until the investment is sold, and even then only 40% of the growth is taxable.

The return from a money market investment can therefore be meaningfully reduced by the much higher level of tax being paid. This is increased even further if an investor sold out of an equity fund to buy into a money market unit trust in the first place. That’s because the initial sale would attract capital gains tax as well.

Here’s the proof

A few examples show how this would play out.

In the first example, someone with an annual income of R2 million sells a R4 million equity fund investment. They have held this investment for some time, and the total gain has been R1.5 million. They then immediately put this into a money market fund, where it earns 7.2% per year.

The below table shows the end result of this investment five years later, after all taxes have been paid, and presuming all interest was reinvested after taxes had been paid.

Impact of moving into a money market fund
  Gains Deductions
Initial investment amount R 4 000 000  
Capital gains tax paid   R 262 800
Interest earned in first year R 269 078  
Tax on interest   R 110 375
Investment amount at end of first year R3 895 903  
Interest earned in second year R280 505  
Tax on interest   R115 517
Investment amount at end of second year R4 060 891  
Interest earned in third year R292 384  
Tax on interest   R120 863
Investment amount at end of third year R4 232 412  
Interest earned in fourth year R304 734  
Tax on interest   R126 420
Investment amount at start of fourth year R4 410 726  
Interest earned in fifth year R317 572  
Tax on interest   R132 198
Investment amount at start of fifth year R4 596 100  

Compare that to how the money would have grown if it had been left in an equity fund. We have used the returns of an average equity fund growing at 3.5% per year, with a dividend yield of 2%:

Investment kept in the average equity fund
  Gains Deductions
Initial investment amount R4 000 000  
Capital gains tax paid   R0
Gain in first year R140 000  
Dividends tax   R 16 000
Investment amount at end of first year R4 124 000  
Gain in second year R144 340  
Dividends tax   R16 496
Investment amount at end of second year R4 251 844  
Gain in third year R148 815  
Dividends tax   R17 007
Investment amount at end of third year R4 383 651  
Interest earned in third year R153 428  
Dividends tax   R17 535
Investment amount at start of fourth year R4 519 544  
Interest earned in third year R158 184  
Dividends tax   R18 078
Investment amount at start of fifth year R4 659 650  

(Note: This calculation is based on 3.5% growth every year, which of course is not entirely accurate since stock market returns do not come in a straight line. It is however the simplest way to display a comparison.)

It is striking that despite the ‘face value’ growth in the equity fund being less than half of that of the money market fund, this individual would be more than R60 000 worse off after five years if they had moved their investment.

What if there are fewer zeroes?

One might argue that this is a fairly extreme example, incorporating a large capital gain and taxing income at the highest rate. It also presumes that someone was prescient enough to make this switch at almost exactly the start of the five-year period.

Let us therefore consider a scenario involving a less wealthy investor, who switches after two years of poor returns. They therefore have three years in the money market fund. Their annual income is R400 000 per year, so they are taxed at 31%, and the amount they have to invest is only R500 000. They have accrued R200 000 in capital gains on this money.

Impact of moving into a money market fund
  Gains Deductions
Initial investment amount R 500,000  
Capital gains tax paid   R 19,840
Interest earned in first year R 34,572  
Tax on interest   R 3,339
Investment amount at end of first year R 511,392  
Interest earned in second year R 36,820  
Tax on interest   R 4,036
Investment amount at end of second year R 544,176  
Interest earned in third year R 39,181  
Tax on interest   R 4,768
Investment amount at end of third year R 578,589  

In this instance, the impact of tax is much lower, so they would be better off than if they had remained in the equity fund, which is shown below:

Investment kept in the average equity fund
  Gains Deductions
Initial investment amount R500 000  
Capital gains tax paid   R0
Gain in first year R17 500  
Dividends tax   R2 000
Investment amount at end of first year R515 500  
Gain in second year R18 043  
Dividends tax   R2 062
Investment amount at end of second year R531 481  
Gain in third year R18 602  
Dividends tax   R2 126
Investment amount at end of third year R547 956  

However, if, instead of the average equity fund, this investor had been invested in the broad market index tracker with the longest history in South Africa – the Grypon All Share Tracker Fund – which grew at 5.5% per year over this period and with a dividend yield of 3.3%, there would not be much difference:

Investment kept in an index tracker fund
  Gains Deductions
Initial investment amount R 500,000  
Capital gains tax paid   R 0
Gain in first year R 27,500  
Dividends tax   R 3,300
Investment amount at end of first year R 524,200  
Gain in second year R 28,831  
Dividends tax   R 3,460
Investment amount at end of second year R 549,571  
Gain in third year R 30,226  
Dividends tax   R 3,627
Investment amount at end of third year R 576,171  

This shows how what might seem like a simple decision is actually far more complicated than it appears. Simply looking at the difference in return between the different kinds of unit trusts does not tell the full story.

Particularly if an investor has to pay a large capital gains tax amount for moving their money, just recovering that loss can take time and therefore take away from the benefit of compounding gains. In the first example, it took two years just for that individual just to break even again.

Investors should therefore be careful about making any decision to move their money without proper consideration of other factors or without professional guidance. Unless they are fully aware of the consequences, they may find themselves worse off than where they started.

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COMMENTS   37

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Patrick, are you still taxing this guy at 45%, when he only earns R400k plus a bit of interest?

Seems to be a common error when making these comparisons. Those of us not in the top tax bracket can actually do pretty well earning our small amounts of interest. Especially if some of this was in a tax-free account.

And 7.2% is slightly below the actual rates people can earn by shopping around.

In the second example the tax rate is 31%. Sorry, that maybe should have been explicit.

Yes, there are money market funds giving better than 7.2%, but there are also equity funds doing a lot better than 3.5%. I have worked with averages.

Maybe I’m missing something, Patrick, but R4 847 tax on interest of R34 572, after deducting the exempted R23 800…that’s not 31%. Looks like 45% to me.

And someone over 65 would hardly pay any tax at all after the exemption.

Good spot! Gremlins now eliminated.

Agreed. However do you not need to adjust the final equity figure down for capital gains tax if you want to compare what you really have?

It is always important to differentiate discretionary savings from contractual savings.

In contractual savings (Pension, provident, RA, ILLA) you pay no tax inside the vehicle regardless of the type of investment.

For people in these products, money market funds and other interest bearing products have offered great value, returning up to 10% pa for the last couple years.

Very easy investing with the 20:20 vision of hindsight. If you had looked at the 5 years leading up to 2008 you would have concluded that Equities were the place to be….

Retirement products do offer much greater opportunity for “income” assets but avoiding the short-term pain of poor returns in the ST and higher volatility will leave you with a much higher probability of failure over the long-term.

If we all agree equities outperform any other asset class over time (last 150 years) then when would you want to enter the equity market.? Same can be said for the property funds at this stage.
Death and taxes are certain. What people believe to be forever is laughable.
Who saves for three or four decades these days.? I don’t care how or what asset class you put it in as long as you don’t touch it for three or four decades, the end result will be wealth creation. (Equites, property, gold, art. Cash.) This is why I believe a pension fund or retirement annuity protects one from oneself.

The origin of the initial investment should not matter when you want to compare return on investments (ROI) in different markets.

You should start from fresh. You cannot use historic tax on the original amount and drag it into new comparisons. For instance, if the original investment originates from an inherited lump sum or from an insurance policy or from Lotto winnings, then no capital gains tax is applicable.

Furthermore, use 8.25% for your money market ROI as is currently available from RSA Retail Bonds.

With regard to equity funds, one can move investments between equity funds during the tax year in order to utilize the R40000 annual exclusion on capital gain. This will minimize final capital gain on termination of the investment.

Agreed, though the question the author is trying to answer is not ‘which option produces the better ROI’ but rather ‘which option, stay or switch, produces the higher terminal value’.

To compare terminal values both options should be converted to cash at the end of the comparison period to make a like-for-like comparison; only one will attract capital gains tax. Strange omission, especially since the sub-heading states ‘Don’t forget about the tax.’

I have presumed that these are long term investors, so they are not cashing out their investments at the end. If they are in an equity fund, they would stay in that equity fund. If they had moved into a money market fund, they might cash out and re-invest somewhere else, but there would be no capital gain event in that case.

The informed investor knows way better to be currently fully exposed to general equity funds where the next global bear market (after 10 years of artificially inflated equity markets) is way overdue, inevitable and during which a capital draw-down of 10% to 30% is going to create a great opportunity for the patient investor. Factor that into your analysis.

The “informed investor” is never fully exposed to general equity funds. And what they know about future, is that they have no ideas what it bring. Nor do they try to time markets, by waiting for the next big downturn. Judging by your comment – that markets have been artificially inflated for the past ten years – you’ve had a long wait already.

Here’s a heads up. Two factors drive asset prices: future cash flows AND the rate these are discounted at. And if real risk-free rates don’t return to previous levels (as they may well not, in this high debt/low inflation/sluggish growth world) then asset prices are not going to head south in a big way either. Lower discount rates also mean that far-dated cash flows have more value, which is likely to mute volatility in response to short-term recessionary developments.

Of course, markets can fall over at any time, for some reason we don’t yet know about. But waiting for that to happen is not an investment strategy, and pronouncing on valuations (suggesting that all investors – except you -are getting is wrong) requires some hubris.

yes..but not the same if you had your pension fund in cash the last 3 years…cash till the crash…then I will invest

Having read (and enjoyed) many of Patrick’s articles I must give him credit for trying to illustrate an important point.

Trying to get all the permutations around individual tax rates, taxable, tax deferred (Retirement funds) or tax free accounts and time horizons to stack up without writing a short book is difficult.

The message I think is to always consider things a little deeper than simply at face value.Anyone who models anything in the personal finance space knows you can pretty much torture the stats to tell you whatever you want them to.

An additional point would be to consider the “risk aspect”.

The purpose of investing in equity markets versus cash over time is to earn excess returns. Even if the returns are similar you are still better off in cash as your downside (particularly in the current environment)is completely different and as someone earlier mentioned the value of the “option” cash provides in a market correction should not be ignored.

Additionally the psychological impact on investors during a downturn is massive, arguably it has been so even during this flat return period. So its not just investment returns but emotional returns that matter. No matter how much hand holding or coaching you get to stay the course, if you are 5 years from retirement and your portfolio experiences a 20% devaluation your whole perception of risks shifts.

Invest in risk assets when their returns are reasonably expected to be higher…. S&P 500 on a PE of 23x or even JSE AS at 18x is probably not one of those times…

Patrick so in theory your assumptions may be corrected but there are a few things that I’d like to point out that would produce a significantly different outcome which is not based on assumption but rather on factual results from personal experience:-
1. Your rate assumptions over this period is possibly not correct on interest bearing Investments, the average is closer to 8.5% but there was a 6 month window period in which you could actually of get 10% p.a. payable monthly. (5 year F/Deposit, 10% p.a. interest payable monthly.
2. You ignore the dilution effect of Trusts, where you can distribute interest income to beneficiaries, making use of the interest exemption amongst all in addition to reducing the effective tax rate.

I believe Interest Bearing Investments have produced the best returns over the past “5” years relative to risk as we need to exclude things like Bitcoin – The rand to the pound has strengthened pre v/s post Brexit catastrophy,from R23.OO odd to it’s current levels of R17.50 or so. So what you did make on growth in international markets you lost as a result of the rand strength over this “5” year period.
So it’s again all about timing, diversification, time in the market and my favourite which most disagree with is timing the market!
Regards
Toni

I’m not advocating choosing any investment over any other. I am simply pointing out that it’s not as simple a decision as it might appear at face value.

Patrick, to answer your question, yes I am better off in the money market. No guesses, no assumptions – my money market made more money than the unit trust. Also, there was no advisory cost, or fund manager cost, or risk, or… I’m sure you get the point. I do, however, take your point that one should look at tax implications as well, but I’d rather pay tax on money that I actually made than not pay tax on money I didn’t make.

Good article that gets one thinking of Tax implications of some investments.

One important comment though. You will have to pay capital gains tax on equity at some stage(if you ever want you money) :).

Hence you are holding a Tax liability in your equity calculations that has already been paid in the money market example. This will have a significant impact on all your calculations.

This is true, but you don’t need to pay CGT until you sell your holding. Firstly
that means you can continue to benefit from compounding those gains in the meantime. Secondly, if you only sell an equity investment piecemeal to fund your retirement your capital gains liability will not be the full amount as you will benefit from ongoing annual exemptions.

Paying income tax (on an interest bearing investment) is not necessarily a bad thing.

Tax is a clear indication that you’ve made some GAINS at least in a cash fund (as opposed to a loss in a local equity fund). Hence tax is due when one ends up better off.

A “better” position to be in must be those local equity/UT investors having capital losses the past few years. Zero tax liability is great. But it comes with a painful loss in capital!

I’d rather pay the tax, knowing my portfolio has done well…(?)

Spot on Michael! The most successful farmer in the district was listening to the conversation of the group of young farmers who were discussing ways to limit their tax liability. His only reply was: “The more taxes I pay, the more money I have.”

The same goes for CGT.
As far as the article is concerned, the mere fact that we are having this discussion proves that the world has been in a deflationary spiral for the past 5 years. Cash outperforms equity during deflationary times.

To fight deflation and to create inflation is part of the job description of every Central Banker on earth. They own the printing press and they have the power to raise or lower the capital ratios of banks. In short, in the long run, Central Bankers always win and all money market funds always lose.

100%. As economies stagnate the disconnect between the financial economy and the real economy just widens.

The country with the best performing stock market ever? The country with the greatest number of billionaires? The country with the worst real economy ever? Yes. It’s Zimbabwe.

Not the place to have your cash in the bank.

Yep … we switched tax accountants and the consultant asked why we’re paying so much tax! Her other clients aren’t paying any on their funds! I explained that we had made substantial capital gains while her other clients had lost capital over the last three years.

Taraaa!

I am not a financial adviser but anyone that can crunch numbers will see that:

Since we are taxed such a high percentage, the gains from being tax efficient (100% compliant with the law) is much higher than earning an extra 2-4% growth.

I have had some great growth by doing the following:

1. Make sure you use you 27.5% RA allowance each year. You can do this without a broker. (You also save tax on interest/gains here)
2. When moving funds make sure you do not exceed you R40K capital gain allowance.
3. Deduct all medical expenses.
4. Check the interest received does not exceed R22300 (Offshore low risk might serve you better and manage your risk)
I am not into the property game but:
5. If you have rental income make sure you spend money on upkeep and improvements that will increase the value of your property. (Delaying paying tax till the day you sell the property)

Had we not been in cash and bonds earning 7.5% over the last four years we would probably be down at least 10% in assets which would take at least 5 years to hopefully recoup.

A small amount in a tax free fund has stayed at zero growth as has another in an equity fund and a property fund. All we have been doing in these cases is supporting the income of fund managers and their companies.

The tax we pay is far preferable to the losses.

In agreement, Beachcomber

We realise there are times (when??) that equities will outperform cash, but cash was king the past few years.

And the 7+% return on cash exceeded the (official) rate of inflation the past few years….that doesn’t happen very often. Hence you’re in a good spot, even with paying some tax.

(Perhaps look at some cash in an offshore bank account…interest is fully taxed in SA, if declared, but the % rate is low…and you mostly score by making long-term currency gains.) Probably not a bad time now, since ZAR is below R14/US$, to move some abroad. Brenthurst Wealth for one, can assist with Mauritius bank account.

Something is missing is in this analysis, after moving the money into the money market, the investment value after 5 years is R4 596 100. If left in the equity fund, the value is R4 659 650. However the investment in the equity fund is still subject to capital gains tax at withdrawal whereas all tax has been paid for the investment in the money market.

It is quite simple, really. in all instances, at the end of the day, it is k@k en betaal, dis die wet van nTransvaal’

As others have said “Don’t forget the tax” on the equity fund. Even if you die before you spend it , whatever it goes up by will have a corresponding increase in CGT.
Everyone should farm their interest and capital gain exemptions annually so it’s fair to take those out the picture when comparing option A to option B.

Not entirely in agreement with some of the assumptions. This is a 1% target market analysis.

Even for the 1% some missing assumptions like;
1. Seniors Invest for high returns and their exemptions are R10k higher
2. Everyone needs to ha e money in Cash for day to day.

I think it’s worth raising the point that the limits for tax free interest in south africa are so low in comparison to other countries they are a disinsentive to actually saving. R35,000 or so buys very little these days. It’s about time these limits for savers were raised substantially. Of course as the rand depreciates the interest one gets on on an overseas account also goes up, so you hit the limits earlier . Another example of the taxman squeezing the person especially the pensioner who is trying to save.

The examples given above show capital gains tax paid on the selling of equities in one year. If switching say from an Equity Fund to a Money Market Fund most advisers would, I am sure, do this in stages if the capital sums are large as in the first example. One switch in each tax year.

The above examples are more for middle aged or younger clients possibly reflecting the author’s age. Older clients much prefer stable money market returns, say 7.8% (1 year) as stated recently for the Allan Gray Money Market Fund, especially if they are drawing on their funds rather than say the -5.0% (1 year) from the Allan Gray Equity Fund.

The opportunity cost of remaining in the Equity Fund would be 12.8%

Dont forget the fund manager fees, Advisory fees, admin fees, management fees etc etc. These can equal up to 3% PA

After 5 years you down a compounded >15%. Which in the above scenario is approx R70k – R80K.

Why someone would even choose a equity fund manager these days is beyond me when 96% cannot even match the index.

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