By Jonathan Nel, CFP®
The South African government introduced tax-free savings from 1 March 2015. This has allowed South Africans to invest, within limits, into a savings account and pay no tax on the growth of the investment. This investment could be either a fixed deposit or savings account at a bank, or alternatively an open-market investment invested in unit trusts and ETFs through a flexible investment structure or an endowment policy.
The current contribution limits are R36,000 each tax year (R3,000 a month) and R500,000 for the investor’s lifetime. The limits are also available only to natural persons. Any contributions that exceed the prescribed limits will be penalised and taxed at 40%. These limits are subject to change from time to time.
The annual and lifetime limits are accumulative and once-off. In other words, if you invested R5,000 in a particular tax year and a couple of months later in the same tax year, you withdraw that R5,000, you will not be able to reinvest that R5,000 without using up an additional R5,000 of your annual & lifetime allowance. This was intentionally done to discourage withdrawals and in turn encourage long-term savings.
How will a tax-free investment benefit me?
As the well-known saying goes, there are only two certain things in life: death and taxes. Although we have yet to find a way to cheat death or completely escape taxes (legally), good financial planning can help us invest our money in a way to reduce our tax liability and have a more tax-efficient portfolio.
One technique is to incorporate a tax-free savings investment into your savings portfolio. The lifetime and annual limits may seem insignificant, however, over the long term, there is a substantial tax benefit to using this vehicle.
In theory, depending what product you have invested your tax-free allocation to, a tax-free investment can be easily accessible, just like an ordinary flexible investment or savings account. However, the lifetime and annual limits were designed to discourage withdrawals and encourage long-term growth and savings. If we use it in the way for which it is intended, it can complement your long-term savings in a valuable way.
The following graph depicts, in five-year intervals, what your investment’s value would be in real terms (taking out the effect of inflation) if you invest the monthly maximum contribution (R3,000) in an open market, high-equity balanced fund for your tax-free savings versus the same contribution in the same fund but a taxable investment.
Assumptions: 39% tax bracket | 9% IRR | 4.5% inflation | Fund invested in 50% equities, 10% cash, 20% bonds and 20% property | No Tax exemptions or deductions were taken into account for taxed fund | No advice or admin fees were considered |The graph is for illustrative purposes only
As you will see, the longer you invest for, the bigger the effect of paying no tax becomes. In the first five years, the difference is a slight R14,469.38 or 7.99% less in the taxed fund. If we had to take into account exemptions and other possible tax deductions, the difference would be even less. However, from year 15 onwards, the difference becomes quite substantial. In year 15, the fund value is a full 24.79% less in the taxed fund and by year 30, that difference balloons to 52.73% less capital in the taxed fund compared to if you used the tax-free vehicle. This is exactly the way it was designed, to encourage long-term savings: the longer you invest for, the more value you will get out of it.
Tax-free savings: your retirement savings’ new best friend
One of the most beneficial ways to use tax-free savings is to incorporate it to compliment your retirement savings. The two savings vehicles have certain things in common: mainly, they both grow tax-free. There are, however, some key differences. Notably, contributions to retirement funds are tax deductible (within limits) and there are no limits on how much you can contribute to them in a year. However, tax-free investment contributions are not tax deductible and, as we know, they have annual and lifetime limits. The other big difference is restrictions on where you can invest. Retirement funds are subject to Regulation 28, which dictates how much you can invest in riskier assets such as equities; they also limit how much you can invest offshore. However, tax-free savings have no asset class or offshore restrictions. Retirement funds also have withdrawal restrictions while tax-free investments do not (except if you invested in a five-year endowment policy or a fixed-term deposit). Here is a summary of the advantages:
