Are you making the most of your tax-free investment?

With less than a month away from the tax year-end (29 February) we would like to remind South Africans of the great benefits of tax-free investing, provide some guidance on how to get on track and also review the success of this initiative thus far.

Reaping the benefits

Tax-free investment offers each South African the opportunity to invest up to R 30 000 a year (with a lifetime limit of R 500 000) completely tax-free. As a result, investors now have two products to consider within their discretionary portfolio: tax-free and ‘normal’ (non-tax-free investment accounts). The table below illustrates the tax benefit of the same unit trust portfolio used as is, relative to a tax-free investment account.

Your personal tax-saving will depend on your marginal tax rate, the type of fund you choose and how much capital gains you realise at withdrawal. Your marginal tax rate referred to in the second table below, is simply your annual taxable income bracket in the SARS personal income tax table1.

The type of fund you choose depends on your investment horizon, what your existing investment portfolio consists of and your risk and return objectives. Your capital gain potential depends on your marginal tax rate, how much exposure you have to growth assets (like equity and property) and how long you leave your money to grow.

Considerations when choosing your tax-free investment

Investment horizon

It is important to define what you want to achieve with your savings, i.e. short-term liquidity requirements or longer-term goals like a deposit for a house or children’s education. Money withdrawn from a tax-free investment account can’t be replaced, as any contribution made is subject to the annual limit. Therefore, to unlock the true power of tax-free compounding, consider investing your longer-term savings in a tax-free investment account, rather than using it for short term liquidity requirements.

Existing investment portfolio

You also 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. In addition, you must consider the taxability of your existing investment portfolio. Interest earned and capital gains realised per year are exempt from tax up to an annual limit prescribed by SARS1. As a result, the level of income and growth assets in your existing portfolio impacts how and when you will benefit from having income or growth assets in your tax-free investment account.

Using the illustration above, if your existing investment portfolio falls in the bottom left quadrant you are not paying tax on interest earned yet and most likely don’t realise capital gains in excess of the annual threshold yet. This does not mean that you won’t benefit from tax-free investment. If you open a tax-free investment with a high exposure to growth assets, you will get the immediate benefit of 0% dividend tax (compounded over time) and the significant future benefit of 0% capital gains tax when you withdraw. As your exposure to income assets in your discretionary portfolio grows, you will move up to top left quadrant, in which case you can also get the immediate benefit of 0% tax on interest and can consider adding income exposure to your tax-free investment account.

Risk and return objectives

Investment horizon, risk and return are related. The longer you can leave your money invested, the higher your risk tolerance, as you have more time to make-up for the potential negative impact of short-term volatility and still benefit from the power of compounding. Conversely, the shorter your investment horizon (less than three years), the lower your risk tolerance and the more important it is to protect your capital.

Similarly, the riskier the asset, the greater the potential long-term gain. Growth assets such as equity tend to behave more volatile in the short term, but offer greater long-term return potential. Whereas income assets such as bonds and cash tend to be less volatile in the short-term and offer lower return potential in the long term. Property can be seen as a hybrid of income and growth asset characteristics.

Success so far

A study done by Intellidex2 in which they focused on the tax-free investment accounts opened at non-bank providers over the period 1 March 2015 to 30 June 2015, revealed the following:

-  35 000+ accounts were opened

-  32% are believed to be first time savers

-  c.R300 million in total savings

-  20% have already used their full R30 000 annual allowance

-  R8 000 on average invested per account

Considering that these numbers are only for a third of the first tax-year and based on a limited selection tax-free investment providers surveyed, we believe it is a very positive result. However, compared to the size of the working population in South Africa, we still have room for improvement.

1 http://savetaxfree.co.za/wp-content/uploads/2015/09/TFSA-Survey-Report-v2.pdf

2 http://www.treasury.gov.za/documents/national%20budget/2015/sars/Budget%20PocketGuide%202015-16.pdf