In the realm of investment portfolios, South Africa offers a complex landscape, with a myriad of asset classes to choose from. While equities, bonds and real estate often steal the limelight, one asset class that should not be overlooked is cash. Cash serves as a vital component of any well-balanced investment strategy. However, it is essential to understand that cash, though offering liquidity and a degree of security, may not always be the most tax-efficient choice. 

Cash is considered the most liquid asset class, offering investors immediate access to their funds. From an investment perspective, cash refers to money market funds and bank deposits. The liquidity of these bank products provides a safety net, enabling investors to seize opportunities or meet unforeseen financial obligations without incurring significant transaction costs or market risk.

The SARB has, for the last 12 months, embarked on a mass quantitative tightening campaign in order to fight inflation and protect the volatile Rand. This has resulted in interest rates being at their highest levels in 14 years. Generally, a high interest rate environment is bad for borrowers and good for lenders or depositors. However, many individuals have been sitting on substantial pots of cash for quite some time in order to take advantage of these high rates and, whilst the pre-tax return of 8%- 8.50% (current rate) in cash looks appealing, the after-tax return is much less attractive. 

While the appeal of cash is evident, it is essential to understand that, in the South African context, cash investments are not always the most tax-efficient choice. This lack of tax efficiency stems from the tax payable on the interest income generated from cash holdings. Interest income is typically subject to income tax, which reduces the net return earned by investors.

In South Africa, interest income is taxed at the individual's marginal tax rate, which can be as high as 45%. This means that a significant portion of the interest earned on cash investments goes toward paying taxes, diminishing the overall returns on these assets. For high earning individuals, the tax impact can be particularly pronounced, making cash a less attractive option compared to other asset classes that may offer more favourable tax treatment, and also negatively impacting tax on retirement drawings for older, wealthy individuals. 

To illustrate the impact of taxes on cash investments, consider a hypothetical scenario. Let's say an investor, with a marginal tax rate of 45% has R2 000 000 in a cash investment (savings account). The savings account yields an annual interest rate of 8%. This means, after 12 months the investor should have R2 160 000 in the savings account – an increase of R160 000. However, the after-tax return is nowhere near this level. In SA, if you are under the age of 65, the annual interest income exemption for tax purposes is set at R23 800.Thereafter, interest income is taxed at the marginal tax rate (45% in this case). We can therefore work out the real return as follows:

R160 000 of interest earned less R23 800 (exemption) = R136 200. 

R136 200 multiplied by 0.45 = R61 290 of tax payable.

The after tax return is therefore R98 710.

Therefore, what appears to be an 8% return actually equates to around 4.94% after tax. 
In contrast, other asset classes, such as equities and certain bonds, may offer tax advantages. For instance, capital gains tax (CGT) is typically lower than the income tax rate, making these assets more tax-efficient. Moreover, there are tax incentives and exemptions for certain products such as Endowments, Tax Free Savings Accounts (TFSA’s) and Retirement Funds. See table below detailing tax efficiency:

Balancing Liquidity and Tax Efficiency

For investors in South Africa, the decision to allocate funds to cash as an asset class should involve a careful balance between liquidity and tax efficiency. While cash provides the safety of immediate access to funds and the promise of attractive interest rates (at the moment), the tax payable on interest income can erode a significant portion of the returns.

Investors should consider their individual financial goals, risk tolerance and investment horizon when determining the appropriate allocation to cash. Even those with short-term liquidity needs or a conservative risk profile may find there are other more suitable alternatives to cash. A good solution would be to keep no more than R200 000 in a cash savings account, as this will ensure interest income does not exceed R23 800 in the year and no tax on interest income would therefore be payable. The remainder of your savings could then be invested in a diversified income fund or housed in a wrapper/endowment structure. 

Conclusion

Cash as an asset class holds a prominent place in South Africa's financial landscape, offering liquidity and the promise of attractive interest rates, often exceeding 8%. However, it is crucial for investors to recognise that cash may not be the most tax-efficient choice in a country where interest income is subject to income tax, especially for high-income individuals. It is also vital to note the importance of staying within the top 5-6 banks if you are looking to invest in a cash solution. Do not be fooled into unusually high interest rates with unseen risks and rather look to invest in banks with a credible track record and big balance sheets.

Balancing liquidity and tax efficiency is essential when considering cash as an investment option. Investors should evaluate their individual financial objectives and risk tolerance to determine the optimal allocation to cash within their portfolios. While cash serves as a valuable component, a diversified investment strategy that includes tax-efficient assets may offer a more balanced approach to achieving long-term financial goals in the South African context.

 

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