Super-Boost Your Savings, Reduce Your Taxes And Retire Early
Sounds great no?
When you earn one hundred thousand Rand, Dollars or Pounds, how much do you actually get to keep and how much do you have to earn to actually own a hundred grand?
It's fairly well publicised on this blog that tax as a subject scares the pants of me. Despite lots of logical advice and encouragement from readers of this blog I now have not one but two accountants looking after my financial affairs. And yes, it is a waste of money and totally anti-FIRE but it lets me sleep at night.
That however doesn't mean I'm not interested in educating myself about tax and more importantly how to incur the least amount of it whilst staying a responsible member of polite society and paying my way. On the contrary, know thine enemy dear readers!
Unfortunately the subject of tax is also about as interesting as a seminar on the history of algebra. So I've been slowly swatting up on what is apparently also one of the most overly complex ideas in the world. I assume that is to prevent us plebs getting too uppity and asking questions like "So what exactly, do I get for all of my taxes?"
So in attempt to make it a little more interesting a topic, I decided to try and track the journey of some cash to see how much of it I actually end up with at the end. I'm sure I'm no way close to the finer detail but even the rougher detail is a bit of an eye opener when you actually write it down. I guess we all sort of know this instinctively, but it is interesting to track not only the deductions from money earned but also the effort required to keep more of your hard earned.
So for the purposes of simplicity, I'm going to use the good old South African rand and SA tax rates but the formula is pretty much universal wherever you live, just adjust the tax rates according to your country. I'm also going to use the high earner tax rate because that's what I paid for the lion's share of my career and would expect that most people saving for a FIRE lifestyle will be in or will hit the top bracket at some point in their savings journey. I'm going to use R100,000 for the "Imaginary" monthly salary just for simplicity, doesn't really matter what number you use.
So, on with the show.....
So I've just finished a hard month at the grindstone farming unicorns and payday has finally come. I receive my payslip from the head unicorn rancher at Unicorns 4 Africa Pty Ltd and my gross pay for the month is a lovely R100,000.
So first I have to pay SARS (South African Revenue Service) a.k.a. The Taxman. He wants 45%, so that is an immediate R45,000 leaving me with R55,000. I also have a compulsory R150 for UIF (the unemployment insurance fund)
So in my paypacket I end up with R54,850 and R45,150 is taken in tax before I even see the money (45.15% taxes paid)
So the first thing I do is pay the bond (mortgage) and lets say that's R10,000. The interest rate of that bond is prime + 4% and the prime interest rate portion of that bond is 7% (the lowest in 5 decades) so of that R10,000 payment, R700 is also a tax deduction.
Next is the car payment, another R5,000 of which 15% is VAT so add another R750 to tax
Then there's the groceries for the month at R7,500. In South Africa, 19 basic food items are zero rated for VAT but everything else is subject to 15%. Looking at the list, we would benefit on milk, eggs, veg, fruit and the odd tin of pilchards (a personal favourite). Let's say I only pay 12% VAT on the total basket of shopping, so add another R900 to tax.
Then there's electricity, water, sewerage and refuse. That little lot totals R3,500 for the month and is all subject to VAT at 15% (and a lot of other taxes but let's not go there) add another R525
So let's taka quick checkpoint, we have R28,850 of our hard earned cash left and $48,025 of our starting amount has been paid in tax (48%)
We need petrol to get to work so that's R2,000 between us with taxes at around 36% adds a further R720 to the tax bill and then one of the cars needs licensing at R850 which is 100% tax.
Then there's car and home insurance at R3,500, all subject to VAT so R525 taken from that
Health insurance is R5000 but fortunately is not taxed
We haven't had any fun yet and Mrs H is a smoker so lets buy her some smokes. 3 cartons for the month should do it. That's R1,350 paid and a whopping R675 of that to tax
Then let's not forget the alcohol for the month. Lets say R1000 each in wine, beer & spirits of the month drinking either at home or when out with friends. R3,000 in total of which with tax on wine at 11%, beer at 23% and Rum (my tipple of choice ) at R36% that will be an extra R700 in tax
Then we need food, treats and toys for Winston at R1,000. R150 in VAT
Finally, I need some new shoes and Mrs H needs a new outfit for work. R2,500 including VAT at R375
Then Mrs H & I both take R4,000 each for our "Fun Money" for haircuts and gadgets and going out with our friends and generally buying stuff just for us. Let's assume that all is subject to VAT at 15% so that's another R1,200 in tax
So after all the bills are paid and we're fed watered and had some level of enjoyment, we're left with R2,500 to go into savings out of our starting R100,000 and we've paid a grand total of R53,220 being paid away in tax.
Well not quite
The R2,500 we had left that went in the bank gets interest of around R100 but the government takes 15% tax from that so we give them another R15!
So in the end we pay 53.2% tax to the government.
We managed to put R2,500 per month into savings. We'll get interest on that at around 8% oif we find a decent savings account. However, the government will take 15% of all the interest so over the next year that will be around another 1% in tax.
So let's add that to our total tax deductions which are now 54.2% and the final answer to the original question is, to own R100,000 you need to earn R218,340. What the fudge? Shut the front door!
All very interesting but to the more mathematical minded of you, this will be a bit, well...meh?
But there's a moral to this story and it's closely linked to the principals of FIRE and the elusive "Savings Rate". For anyone who is just discovering FIRE, savings rate is simply the amount you save every month divided by your take home pay. So in our example above we saved R2,500 of R55,000 meaning we had a savings rate of 4.5%
Personally, between the time I discovered FIRE was a thing and the time I retired, our savings a rate fluctuated between 50% and 75% , I was a money saving machine people! And from most of the people I've met who are Post-Fi, they will rarely tell you they were lower than 50% and I've met some people who were upwards of 85% (dude, were you living on porridge sitting around a fire made from sticks?).
And this is where hopefully (if you're still reading), I actually get around to making my point....at last.
You see from the somewhat boring but arguably not unreasonably illustrative example of a normal middle class family and their spending, that 54.2% of earned money went to tax? Well do you also see that a large portion of it went on VAT and income tax? Yeah you did.
Well the first somewhat obvious statement is that if you don't spend it and you save as much as you can, you won't incur that VAT on the stuff you can live without. This will result in you keeping more of your money for your early retirement.
The second point is if you put some of your savings into a retirement fund, you can claim tax relief on that and reduce your income tax and you won't pay tax on the gains until after you withdraw it when you retire (and you'll probably pay a lower tax rate then).
And finally, if you use your full Tax Free Savings Allowance (currently R36,000 per year), you won't pay the 15% withholding tax on the interest in that account.
So to illustrate that, and don't worry, I'm not going to do massive drawn out math again, here is an example of the same scenario for someone who is saving for really retirement.
Get paid R100,000 pay R45,000 in income tax
Pay R27,500 (27.5% Allowance) into a Retirement Annuity and recover R12,375 in income tax
Pay R3000 into a TFSA and pay no tax on interest
Pay R10,000 to the bond/mortgage with R700 tax
Sell the car and pay off the finance using the left over equity to buy a cheap run around outright
Cut the grocery bill to R4000 with R480 in tax
Stop smoking and cut the drinking to R1,500 with R350 tax
Insurance drops to R2,500 by shopping for a better deal and having a cheaper car. R325 tax
Make do and mend on the work clothes and get your shoes fixed for R500 and R75 tax
Take R2,000 each allowance and do more things that don't cost so much together. R600 Tax
Buy Winston's food in bulk and let him play with the 100's of toys he's' already got for R500 and R75 tax
Actively monitor the electricity usage and minimise it to bring the rates down to R3000 and R450 tax
Some fairly strict but hardly oppressive belt tightening has left us with a spend of R24,500 and monthly savings of R30,500.
More importantly, the tax paid is reduced to R35,680 or just 35.7% and we won't pay any withholding tax on the savings. In this scenario to own R100,000 we only need to earn R155,520. That's almost R63,000 less than scenario 1.
This gives us a savings rate of 55%. With living expenses of just R24,500 our early retirement figure would be R7.35m (300 times your monthly living costs).
If we were saving R30,500 per month and could achieve the same 8% return as the first scenario, we could retire in just under 12 years. If you're in your 30's, that is you out in your 40's with 50 years of chillin' people.
As many of you know, I target between 9.5% - 12% for my investments and have been hitting that fairly consistently so if you use an average of that at 10.75%, that timeline drops to 10.5 years. Damn, I wish I'd known that when I was 20.
A very numbers heavy post this week but hopefully if you stuck with it, the moral of the story came out. By saving hard and being tax efficient you can super-boost your savings and knock decades of your retirement age.
Until next time, keep living