Why investing for the income tax rebate is backward thinking?
An income tax rebate is a popular tool used by governments to encourage people to invest in certain financial products or start businesses. There are good reasons for the rebates, but if you’re holding an investment or in business for the tax advantages, I’m afraid to say you’re doing it for the wrong reasons.
Here are a few examples:
1. Pension funds enable one to place pre-tax money in an investment fund for retirement. In South Africa, pensioners can withdraw a specified lump sum from their funds at retirement without incurring any tax. The rest gets paid out on a monthly basis (known as an annuity) and incurs tax.
The tax-free withdrawal is often cited as a good reason to invest in a pension fund, and is used by the government to entice people to save for their futures.
2. Retirement annuities are widely used in South Africa to help supplement pension fund savings. Instead of using pre-tax money, annuities are investment vehicles for post-tax money. To draw people into these products, tax rebates are offered on annual contributions.
Interestingly, a colleague of mine mentioned to me today that her retirement annuity performed very poorly over the past couple of years. When I asked what her intentions were with the product, she mentioned that she’s staying put because of the tax benefits.
3. Buy-to-let property is a great way to build wealth. However, some individuals purchase rental property for the tax rebates.
For example, if your rental income for the year was $6000 and your expenses $7000, your annual loss is $1000. Say your personal income tax rate is 40%, the government will pay you $400 for sustaining the $1000 loss.
The odd thing is that people get excited when the government pays up, so good that it prevents some investors from selling loss-making assets.
4. The government also uses income tax rebates to encourage entrepreneurship. Company tax is set at 28% in South Africa, whereas the highest personal income tax bracket is at 40%. From a tax point of view, it is more advantageous to conduct business out of a corporate entity than to work one’s way up the corporate ladder.
Let me ask you the following questions:
- Would you rather pay the government income tax or receive a tax payment from the government?
- Would you rather invest in a fund that performs poorly but offers a tax benefit, compared to a fund that performs well but offers no tax incentives.
Be honest.
The only time you pay income tax is when your business or investments make a profit. A profit is a good thing. Conversely, if your assets make a loss you may receive a tax benefit from the authorities like with real estate. Remember a loss is not a good thing.
Now let me ask:
Is your investment or business objective to make a loss or profit? Then why take up an asset for the tax benefits? Why hold onto a loss-generating business solely for the tax compensation.
The lesson is, you must buy or hold on to an investment or business if you are confident that you will be rewarded for your efforts, in terms of profit and return, not in tax.
To use a silly example, one normally goes on an ocean cruise for the entire experience, not for the tasty chocolate muffins. Income tax rebates should be treated as a value-add, not as a primary tool to make important business decisions.
