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Personal investing

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

Tamryn Lamb and Twanji Kalula unpack the pros and cons of using tax-free investment accounts over the long term and explain how they can be used to complement your existing goals.

As long-term investors, we often say that there is no such thing as a free lunch: Performance is seldom delivered in a straight line, get-rich-quick schemes usually end in disappointment, and building long-term wealth takes time. This means that long-term investors must exercise patience, have conviction in their investment strategies, and apply a consistent approach in order to meet their investment objectives. This is also true of tax-free investment products: The real benefits are derived over longer periods of time.

The National Treasury introduced tax-free investment accounts in 2015 to encourage South African households to save. Of course, before we can understand what the concept of a “tax-free” investment is, we must first understand the taxes that are typically levied when we invest. Many of us are no doubt aware of the taxes we pay regularly, such as pay-as-you-earn tax (PAYE) and valued-added tax (VAT), but are probably less familiar with the taxes we pay through investing. In short, in a simple unit trust that is not part of a retirement product, investors are subject to various income and capital gains taxes which will impact the net investment returns that are achievable. 

What taxes do we pay on a simple local unit trust investment?

By way of example, let’s take a look at the taxes one would pay on the returns generated by a local unit trust investment. The returns generated by a unit trust are generally derived from the capital growth of the unit trust’s underlying assets, interest, and dividends. The contribution from each type of return will depend on the type of unit trust that you select. Each of these returns is treated differently for tax purposes.

▪  Interest: Any interest generated by the underlying assets in your unit trust account is taxed at your marginal tax rate. An exemption for local interest of R23 800 applies if you are under the age of 65 and R34 500 if you are 65 or older.

▪  Dividends: Investment managers are required to withhold 20% in tax on any local dividends earned by South African tax resident individuals, while any dividend income from a real estate investment trust is taxed at your marginal tax rate.

▪  Capital gains: When you sell your units, either by switching to another unit trust or realising your investment through making a withdrawal, you may be required to pay capital gains tax (CGT) on the growth of your investment. When calculating CGT, R40 000 of the sum of capital gains or losses for the tax year is excluded in determining the net capital gain. Thereafter, 40% of the net gain is taxed at your marginal tax rate.

These taxes, however, do not apply to tax-free investment accounts as these investments allow investors to invest a limited amount of capital without having to pay any tax on the income or capital gains generated during the life of the investment. This offers investors the opportunity to accelerate their capital growth over time by boosting the rate at which their money compounds.

Understanding how these products work and making sure that you use them optimally in your portfolio can prove rewarding.

The real benefits of tax-free investing are derived over long periods of time

A building block for long-term investors

Tax-free investments (TFIs) are an appropriate choice for most investors with long investment horizons. As such, many financial planners consider them an essential component of any personal financial plan: TFIs are easy to start, they can be used to achieve a range of financial goals, and they offer investors the flexibility of access to their money if they really need it. However, the amount you are able to invest in TFIs is limited. The current legislation allows taxpayers to contribute a maximum of R36 000 to TFIs each tax year, subject to a maximum lifetime limit of R500 000. Importantly, this is a once-off allowance on contributions. If you withdraw from your TFI and subsequently reinvest, this will be counted as an additional contribution and will impact your annual or lifetime allowance. It therefore makes sense for most investors to place the first R36 000 of long-term savings they have available to invest into TFIs each tax year, and then to view these funds as a long-term investment.

TFIs can be used to complement your existing financial goals in the following ways:

Supplementing your retirement savings

A TFI is not the only product that offers tax incentives; retirement products such as retirement annuity accounts and other forms of pension savings also benefit from various tax savings. These products are typically not restricted in terms of how much you can invest in them, but do have limitations in terms of when you are able to access your savings. TFIs can therefore be used alongside these retirement products to supplement your ongoing savings for retirement. This provides some flexibility, should it be required, and also increases the amount of tax-free cash potentially available to you when you retire. This tax-free lump sum can prove useful as you transition into retirement. 

Investing for future educational needs

Many parents and grandparents make use of TFIs to save for their children’s long-term educational needs, or to build up a large lump sum that can be used to give their children a financial head start later in life. You can contribute to a TFI at any age – making it possible for you to invest on behalf of a minor from the day they are born. In fact, approximately 15% of Allan Gray’s TFI accounts are held by investors under the age of 18. However, it is important to remember that if you contribute to a TFI on behalf of a child, you are making use of their TFI lifetime limits and they will not be able to make any further contributions after they have reached their limits. Of course, the earlier you start, the greater the potential for compounding of your capital and other gains and, by extension, the greater the potential tax saving. 

Planning your estate

The Allan Gray Tax-Free Investment is structured as a life policy, which introduces some estate-planning advantages. When you open an Allan Gray Tax-Free Investment, you are required to appoint beneficiaries who will receive the proceeds of your investment in the event of your death. These proceeds are not paid to your estate but directly  to your beneficiaries as soon as we receive confirmation of your death. This means that your beneficiaries have access to some money as the rest of your estate is being wound up.

Understanding how these products work and making sure that you use them optimally in your portfolio can prove rewarding

The real benefits are realised over the long term

The real benefits of tax-free investing become more pronounced over longer periods of time. For example, a R100 000 investment in the Allan Gray Balanced Fund at the end of 2005 would have grown to R445 149 (a 10.47% p.a. return) by the end of 2020, before taking  tax into consideration. This return is reduced to R350 269 (an 8.72% return) after the applicable taxes have been considered. When you factor in that you will not pay any capital gains tax when you realise the value of the TFI, you can see how your net returns have the potential to be meaningfully greater over long periods of time.

Times have been tough and, understandably, many investors have had to dip into their various investments, but this does suggest that some investors may be using TFIs as a short-term parking solution for emergency or other reserves. This is not ideal from a tax perspective as you cannot replace money that you withdraw from a TFI (i.e. your lifetime contribution limit is finite) and you lose out on the longer-term benefits of tax-free investing. Unless the regulations change, a basic unit trust may be a better solution for these goals as they offer the same flexibility of access to savings in emergencies and do not use up your TFI annual and lifetime contribution limits.

Making the most of tax-free investing

There are six things you can do to improve your outcomes and maximise the benefits that TFIs offer: 

▪  Choose an appropriate investment vehicle: South Africans have access to a broad range of TFI products, including fixed deposits, savings accounts, retail savings bonds and unit trusts. Each of these products is invested in one or more underlying asset class (e.g. cash, bonds, equities and property). If you are planning to be invested for a long period of time, you should make sure that the underlying assets in your TFI can deliver meaningful growth. You should also ensure that the underlying assets in your TFI product are appropriate for your goal. 

▪  Maximise your contributions: If your circumstances allow, you should aim to maximise your TFI contributions each year. This will give your investment a broader base to compound off over time – drastically increasing your potential returns. You can automate your contributions by setting up a debit order. If you aim to contribute your maximum allowance each year, it will take you approximately 14 years to reach your lifetime contribution limit. 

▪  Stay invested for as long as possible: The real benefits of tax-free investing are derived over long periods of time. If you may require access to your money in the shorter term, you should consider investing it in a low-risk unit trust investment, as any money that is withdrawn from a TFI cannot be replaced. 

▪  Stay within the limits: Your contributions to TFIs are currently limited to R36 000 per tax year and R500 000 during your lifetime. A hefty penalty of 40% is levied on any contribution that exceeds these limits. If you have TFI accounts with various investment managers, it is essential that you monitor your contributions across all these investment accounts to avoid exceeding these limits.

▪  Do not withdraw; transfer: You can transfer an existing TFI from one investment manager to another. Provided that you follow the correct process, the transfer will not be seen as an additional contribution and will not affect your annual or lifetime contribution limit. Avoid withdrawing from one TFI account with the intention of contributing the proceeds to another TFI account as this transaction may be seen as an additional contribution and impact your annual and lifetime contribution limits.

▪  Think about your financial plan: Your TFI is just one component of your broader financial plan. Whether you are using it as a vehicle to save for your children’s tertiary education or to build a nest egg to supplement your retirement savings, you should have clarity around why you are contributing to a TFI product and ensure that it is fit for that purpose. An independent financial adviser can assist you in setting up a holistic plan that takes your future needs and goals into consideration.

Maximising your tax-free contributions for the current tax year

The current tax year ends on Tuesday, 28 February 2023. If you would like to top up your existing Allan Gray Tax-Free Investment for the 2022/2023 tax year or start a new one, you need to submit an instruction by 14:00 on Tuesday, 28 February 2023. This instruction must be accompanied by the relevant payment, which must reflect by this date. Electronic collections must be processed by Monday, 27 February 2023. 

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