Tax-free investments (TFI) have certainly taken off as the ‘no-brainer’ investment of choice in South Africa in the past two years, with over 260 000 new TFI accounts being opened in the first tax year alone according to the Intellidex Survey1. At Nedgroup Investments, the total contributions to TFI accounts have more than doubled so far in the second tax year, with one of the most popular months for tax-free investing (February) still to come.
While the growth on TFI contributions is excellent and very encouraging, there are still many who believe that the contribution limits of R30 000 per year and R500 000 per lifetime do not make it worth their while.
Why is it a no-brainer?
In short, 0% tax. The growth on your tax-free investment portfolio is boosted throughout your investment time frame by being exposed to:
- 0% tax on dividends earned (instead of 15%)
- 0% tax on interest/income earned (instead of your marginal tax rate on interest earned above the annual exemption)
- 0% tax on capital gains realised at withdrawal (instead of up to 16.4% on gains above R40 000)
The graph below shows, in rands, by how much you can expect your TFI to grow and how much value the 0% exposure to tax can add, by simply investing R2 500 per month until you reach your lifetime limit. Let’s take the low equity balanced unit trust as an example:
- On your lifetime contribution limit of R500 000 (the dark orange block) your expected after-tax growth, i.e. the return you would earn in a normal, taxable unit trust, is R447 000 (the green block), leaving you with an after-tax expected value of R947 000.
- However, because you do not pay any tax on interest or dividends earned during your investment time frame, you can expect an additional R148 000 of growth (grey block) and, since capital gains realised at withdrawal are not taxed, another R37 000 at the end of this time frame.
- This adds up to an expected value (EV) at the end of the time frame of R1.132 million, instead of the after-tax expected value of R947 000.
The expected values over shorter time frames of three to 10 years tell the same ‘TFI is a no-brainer’ story. For example, if you stick to this monthly discipline for five years in a high equity balanced fund, your R150 000 contribution can be worth almost R200 000, or over a 10-year period your R300 000 contribution can almost double to R540 000. In addition, you are not subject to any capital gains tax (CGT) at withdrawal and you will be able to put the full expected value in your pocket, unlike withdrawing from a normal unit trust investment.
How do you choose the right TFI for yourself?
Finding the balance between time, risk (both your tolerance and appetite) and return is vital to successful investing. The more time you have the more risk you can take and the more risk you can take, the higher the return you can expect to be rewarded with. Or, the greater the rate of return you need to achieve, the greater the level of risk you need to accept. And the greater the level of risk of an investment, the longer the time frame you may need to be able to achieve your goal.
So ask yourself the following questions about your TFI:
Are you saving for something specific?
- Whether it is to buy a car or a house, boost your retirement savings or just save, giving your investment objective a name helps you to establish a clear time frame, determine your required return and remain focused on what you are working towards.
What is your investment timeframe?
- Time frame drives risk tolerance. A longer time frame increases your risk tolerance, as you have more time to make up the potential negative impact of the short-term volatility of higher-risk investments and still benefit from the power of compounding. Conversely, if your time frame is short (less than three years), your risk tolerance is low and capital protection essential. In this case, you might want to reconsider whether your TFI is appropriate for this specific savings as you are not able to 'replace' your annual or lifetime contribution limits once withdrawn.
What is your risk appetite?
- This is the emotional side of risk. How many ups and downs can you stomach along the way? You need to understand the investment journey (or potential short-term rollercoaster) you can expect from an investment and be sure that you will be able to stick to the plan for the full time frame.
The diagram below is a simplified illustration of how these three questions drive the type of investment you can consider for your TFI.
Other important considerations are of course how your TFI fits in with your overall discretionary portfolio and your tax profile, as we discussed in a previous article2. You need to be mindful of the type of assets you are already exposed to, to ensure you don’t unintentionally put all your eggs in one basket. Also, since interest earned and capital gains realised per year are exempt from tax up to an annual limit prescribed by SARS3, you can earn interest and realise capital gains tax-free in your discretionary portfolio up to a certain limit. Therefore, the level of income (e.g. cash) and growth (e.g. equity) assets in your existing portfolio impacts how and when you will benefit from having income or growth assets in your tax-free investment account.
For more information or to start your tax-free investing, visit our dedicated tax-free page. http://www.nedgroupinvestments.co.za/NewsInsights/TaxFreeInfo.