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Maximising the benefit of a tax-free investment

By Opinion Time of article published Jun 11, 2021

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By Hugo Malherbe

South Africa has one of the lowest household savings rates in the world. To encourage the culture of savings, the government introduced tax-free investment and tax-free savings accounts in 2015 to incentivise good savings habits. Today, tax-free investments appear to be a popular choice but still remains an underutilised opportunity. Let’s unpack the ways in which tax-free investments can benefit an investor portfolio.

Contribute wisely and within the limits

With tax-free investments, an individual can contribute up to R36 000 per tax year and up to R500 000 over their lifetime, where the interest, dividends; and capital gains are earned tax free. It’s important to note that any amount exceeding the annual or lifetime contribution limit will be subject to significant tax penalties (taxed at 40%), that could erode the value of your investment. The contribution limit applies to all the tax-free accounts held in the individual’s name.

Even though one can access their tax-free investment at any time, withdrawals cannot be replenished. Tax-free investments are best-positioned for building wealth over the long-term.

Using tax-free investments as part of a retirement savings plan

Due to the long-term nature of tax-free savings, the tax benefits, accessibility and flexibility, it is often considered as part of a retirement savings plan. While a tax-free investment is not designed to be your sole source of retirement savings, when coupled with retirement fund savings, it presents an opportunity to boost your nest egg with a tax-free lump sum at retirement along with the retirement fund savings that secures a regular annuity income.

The tax-free investment is also not subject to Regulation 28 (part of the Pension Funds Act) which limits the percentage allocated to certain asset classes. Thus, the tax-free investment offers more freedom around choosing investment options that align to an individual’s retirement savings goals and plan. With no restrictions in terms of asset allocation on tax-free investments, one could invest 100% in any asset class, for example: global or SA equity depending on one’s needs and ensuring adequate diversification across one’s portfolio.

Even though the contributions into the tax-free investment account are not tax deductible like retirement savings contributions, what makes the tax-free investment account a powerful investment vehicle is the compounding effect of the tax savings over time, coupled with the investment growth. With retirement savings contributions into a retirement annuity fund, a pension fund or a provident fund, you can claim back up to 27.5% of remuneration, or taxable income up to R350 000, in a tax year. While both options present tax-efficient ways to save towards retirement, it is essential to view your investments within the context of your holistic financial plan.

Invest early and stay the course

When investing, it’s best to start early and remain invested for the long-term, as it offers more potential of boosting one’s wealth in the future. Even though the tax-free investment limits the contribution to R36 000 per year, the principle of a little can go a long way applies here. To demonstrate this, consider the example below that illustrates the net worth of two people after 40 years with one in a tax-free investment account and one in an investment account:

  • Investor A contributes R1000 per month, from the age of 20 until retirement at 60, into a tax-free investment account.
  • Investor B contributes R1000 per month, from the age of 20 until retirement at 60, into an investment account. After 40 years, both investors contributed a total of R480 000 but the total investment value of investor A was R3.491 million and investor B was R3.130 million. This demonstrates the power of saving money in a tax-free investment account.

(Assumptions: annual growth of 8%, marginal tax rate of 30%, investor B used CGT exemption)

Augment your portfolio with tax-free investments

In addition to the tax benefits, tax-free investments should be part of any financial portfolio. Tax-free investments can be used as a strategic part of your financial, retirement and estate planning. Furthermore, it affords you the opportunity to diversify your portfolio exposure across asset classes (bonds, cash, equities, etc.) with no limits or restrictions, that is suited to your unique financial needs. Consult with your accredited financial adviser on maximising tax-free investments to bolster your financial portfolio.

Hugo Malherbe is the Executive Product Development at PPS Investments

PERSONAL FINANCE

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