How to maximise the benefits of tax-free investing

The deadline for tax-free contributions for the 2017/18 tax year is 28 February 2018, so make sure you’ve maximised your R33,000 annual limit. The benefits can be considerable over time.

Tax-free investment products have now been available to investors for nearly three years. While this is a very short history, a 2017 survey among investors has highlighted some shortcomings in the way they are being used, including:

• Investors seem to be discouraged by the strict investment limits of R33,000 per year and a lifetime maximum of R500,000;
• The majority of tax-free products (59%) are being opened through banks, resulting in the majority of assets sitting in short-term cash (51%) or near-cash (8%) investments.

Here are some considerations as to how you can maximise the benefits these products offer, particularly in light of the early observations above.

Develop an appropriate long-term investment strategy

As a first step, it’s important to develop a holistic financial plan for yourself (and your family).  Such a plan should include a suitable overall investment strategy with the appropriate asset allocation that will enable you to meet your long-term investment objectives. Only once you have this in place should you start to optimise your plan for tax by considering all the available options like tax-free investment products, retirement annuities (RAs), and the annual tax exemptions for income, interest and capital gains tax (CGT).

Remember to invest for your family

While the evidence shows only 30% of tax-free investors have invested the full R33,000, there are those who are concerned that the R33,000 limit per individual per year is a relatively small amount of capital on which to save tax. However, they should remember that children can also contribute up to the annual limit. A family of four could therefore be contributing R132,000 every year (or R11,000 per month), subject to a collective lifetime limit of R2 million, a substantial sum of money to invest tax-free in anyone’s book.

Choose long-term growth investments

The primary concern with using a bank cash account as a tax-free investment is that they invest in short-term cash assets that earn real (after-inflation) annual returns of 1%-2% over the long term, which is substantially less than the 6%-8% provided by growth assets like equities and listed property. Being free of all taxes, the returns on these longer-term investments, re-invested and compounded over many years, will likely be much more powerful than cash investments. So while cash can offer high tax savings, its potential long-term investment return is low, making it less appropriate as part of a long-term investing strategy.     

As an example of how tax-free investments could best be used alongside other vehicles as part of a long-term investment plan, consider a typical family of four:

• Both parents could invest up to 27.5% of their taxable income in their company retirement funds, up to a maximum R350,000 each annually.
• The family could then invest up to 4 x R33,000 annually in tax-free savings vehicles. With no retirement investment restrictions (dictated by Regulation 28), they can hold more than 25% in offshore assets or listed property, and more than 75% in equities. This flexibility could effectively counterbalance the Reg 28 limitations imposed on retirement annuities if the family requires it as part of their long-term strategy – for example, they may need more exposure to equities or offshore assets. Also remember that they can access these funds at any time. 
• With any additional savings, the family could then invest in unit trusts in their own names, and by using their combined annual interest and CGT exemptions, this could result in another substantial amount invested effectively tax-free. For example, they could each invest up to about R1.6 million in the Prudential Balanced Fund and pay no taxes on their earnings by using their exemptions. Again, no investment or liquidity restrictions apply on these investments.
• Finally, if the family’s marginal tax rate is over 30%, they can then consider investing in an endowment.

So by using tax-free investments in combination with other vehicles and allowances as part of a holistic, long-term investment plan, you can optimise your family’s overall investment portfolios quite substantially – and these tax savings together with an optimal investment strategy could have a significantly positive impact on your long-term returns.

Don’t forget that the deadline for topping up your tax-free investment for the 2017/18 tax year to the R33,000 annual limit ends on 28 February 2018. Prudential offers a range of five tax-free unit trusts to suit a variety of risk and return requirements. To invest in our tax-free unit trusts, complete an online application form now. Alternatively, for more information, contact our Client Services team on 0860 105 775 or at query@prudential.co.za.

This article was originally published on 02 February 2017 and was updated on 24 January 2018 to reflect the changes to annual contribution limit.