Extracting maximum value from a Tax Free Savings or Investment Account will require patience and discipline, according to Niel Fourie, public policy actuary at the Actuarial Society of South Africa.
After all, adds Fourie, these new investment vehicles were designed to help alleviate South Africa’s dismal savings rate by incentivising consumers to save and invest more over the long-term.
Tax Free Savings and Investment Accounts, introduced on March 1 this year, attract absolutely no income tax, capital gains tax or dividend withholdings tax. You are allowed to invest a maximum of R30 000 a year into a tax free account, but you may not exceed the lifetime limit of R500 000. If you do go over these limits, the Receiver of Revenue will slap you with a 40% tax penalty on contributions above these thresholds.
Also, while you are allowed to withdraw money from a tax free account, you cannot replace that amount at a later stage as it will be seen as a new investment that will come off your lifetime allowance.
Tax free enhances compounding
Fourie explains that the limited contributions allowed by a tax free account, combined with the existing tax free annual exemptions on interest and capital gains tax, mean that the initial benefits of a tax free account are relatively small when compared to a normal savings or investment account.
According to Fourie only once the R500 000 cap has been reached, will the real benefit of the tax free nature of the investments become apparent. If you invest R2 500 a month or R30 000 a year, it will take you close to 17 years to reach your R500 000 lifetime limit.
While this means that you will have to view this as a long-term investment in order to get the maximum benefit from compounding, the return could be substantial depending on the savings or investment vehicle chosen.
Compounding refers to the growth achieved on your original investment plus the growth on the returns already earned. If you are earning interest, compound interest is best described as interest earned on interest. In the case of a tax free account you benefit from compounding on tax free interest, dividends or capital gains. With all other investments interest is taxed at the investor’s marginal tax rate, which could be as high as 41%, capital gains tax of up to 13.7% and dividends tax of 15%.
“The compounding effect on a tax free investment is therefore even more significant, because growth is achieved on the original investment as well as on the untaxed returns.”
Accumulating tax free lump sums
Fourie says a R2 500 a month investment over 16.5 years into the equity market would grow to around R1.62 million, after all taxes are deducted assuming a 13% net return before tax. Had the same investment been made into a tax free equity unit trust fund, the available tax free lump sum would have been R1.7 million.
As depicted by the graph below, this would mean R80 000 more for the investor who used a tax free investment vehicle over the past 16.5 years. An investment that is not tax free would furthermore attract capital gains tax (CGT) once the units are sold. The actual CGT will depend on whether the CGT allowance has been used.
Fourie says if you managed to invest your R500 000 lifetime allowance by age 45 (assuming you started investing in a tax free account at 28) and, using the example above, left your R1.7 million tax free lump sum undisturbed for another 20 years, you would be able to retire at age 65 with R6.1 million tax free in real terms.
The R1.62 million, on the other hand, would have grown to only R5.3 million, because the 15% dividend withholding tax drag (approximated at 0.5% a year reduction in return) makes a 13% difference over 37 years. In addition, CGT will further reduce the proceeds.
The graph below shows how the value of a tax free investment account increases with time when compared to a normal unit trust. After 30 years the tax free investment will be about 10% higher than the normal unit trust and after 65 years about 23% higher. This is before CGT on disposal of the unit trust is taken into account. Bringing CGT into the picture means the tax free investment could be up to about 25% higher after 30 years and up to 40% higher after 65 years.
Fourie points out that you can also invest on behalf of your spouse without having to pay donations tax. If you invest on behalf of your children, there will be no donations tax as long as the amount does not exceed R100 000 in a tax year. You do need to bear in mind, however, that since the investment must be held in the name of the person on whose behalf you are investing they lose their lifetime allowance.
“Whether to invest in tax free savings and investment accounts and how much should form part of your long-term financial planning. This is best decided with the help of a trusted financial adviser,” reminds Fourie.
*Niel Fourie is a Public Policy Actuary at Actuarial Society of South Africa