TAX-FREE INVESTING FEATURE
29 February 2020
FAREEYA ADAM Head: Product Solutions, Momentum Investments
How to create money magic with tax-free investing
T
ax-free investment products have been around for a while. Some clients are using these products as part of their financial plan, some are using them but not making the most of it, and some are not using them at all. Financial advisers know the major benefit of investing tax free, as depicted in the graph below.
Every R1 invested in a tax-free investment can grow to R6.73 after 20 years, assuming a yearly return of 10%. At a tax rate of 30%, the R1 will only grow to R3.87. But it could be difficult to bring home the true benefits to clients because of mixed messages in the media: you don’t want to encourage withdrawals even though they have easy access to the money at any time. The tax-free feature of this investment will be most beneficial when one starts early in life and keeps it until retirement or beyond.
PIETER HUGO MD, Prudential Unit Trusts
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hen investing in unit trusts, it’s important to be aware of the various taxes associated with your investment, particularly if you’re considering taxfree unit trusts. The impact of taxes on your portfolio differs according to your individual circumstances (such as your marginal income tax rate) and the underlying assets that you are invested in. While it’s fairly straightforward that the higher your marginal tax rate the greater the potential tax saving over time, the latter component may be slightly less obvious. If you own bonds or cash in your unit trust, you will incur tax on the interest income they pay out. Cash can include money market funds, bank deposits and any other short-term investments that pay out interest, apart from bonds. Your interest income is subject to income tax, and is taxed at your marginal
Clients will get the most out of the investment by: • investing as much as they can, within the limits; • investing as much of the allowable yearly amount as early in the tax year as possible; • investing in growth assets; and • leaving their money invested for as long as possible. Clients will override the advantages by: • using the investment as an emergency fund or for other short-term needs; • withdrawing any amount before retirement; or • investing in conservative underlying assets, such as fixed interest. Let’s have another look at how time and tax-free compounding can work for a client. If we assume the yearly limit of R33 000 (R2 750 per month) is too high for a young person, let’s look at R1 000 per month. If the client can afford a 6% increase every year, it will take almost 22 years to build up to the lifetime limit of R500 000. If the client in our example starts investing at the age of 25, this is how the value will increase if we assume inflation at 6% and a return of 10% a year (CPI + 4%).
IF CLIENTS HAVE THE DISCIPLINE TO INVEST TAX FREE, AND STAY INVESTED, THEY WILL REAP THE BENEFITS
Investment period 25 years 30 years 35 years 40 years
Investment value R1 959 927 R3 156 481 R5 083 545 R8 187 100
Note: Excludes the effect of fees.
If clients invest in a Flexible Tax-free Option from Momentum Wealth, they get the following added benefits: • We offer the widest choice of underlying investment components to suit each client’s investment needs and goals. • Our outcome-based solutions fund range targets specific growth outcomes, making the choice of investment funds so much easier. • We offer cost efficiency, even more on our Target range of funds where we use passive-style investing with an active twist. • We make sure clients don’t exceed limits with us, to avoid tax penalties. If clients have the discipline to invest tax free, and stay invested, they will reap the benefits. With growth assets and time on their side, they will enjoy money magic. Momentum Investments is part of Momentum Metropolitan Life Limited, an authorised financial services (FSP6406) and registered credit (NCRCP173) provider. Momentum Wealth (Pty) Ltd is an authorised financial services provider (FSP657) and part of Momentum Metropolitan Holdings Limited.
Tax-free investments: A closer look at the benefits tax rate. Individual taxpayers enjoy a specified annual exemption on all South African interest income they earn, set by SARS every year. For the 2019/20 tax year, this exemption is R23 800 for individuals under 65 years old and R34 500 for individuals 65 years and older. For equities (excluding listed property companies), you will incur dividend withholding tax (DWT) on the dividend income they pay out. DWT of 20% is withheld from your dividends before they are paid out or reinvested. The tax regime associated with listed property companies in the form of Real Estate Investment Trusts (REITs) is more complicated than other asset classes. REITs do not pay corporate income tax, and investors must pay income tax (at their marginal tax rate) rather than DWT on their distributions. Capital Gains Tax (CGT) is another tax associated with investing
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in both equities and property. A capital gains event is triggered only when you sell your investments at a profit. Currently, an amount of 40% of this capital gain is included in your annual income; this makes the maximum CGT rate for individuals paying the maximum 45% marginal tax rate 18%. Note that individual taxpayers currently enjoy an annual capital gain exclusion of R40 000. Which tax-free investments offer the most tax benefit? From the above, it is difficult to determine which types of tax-free assets would offer the most benefit, since it depends on your unique circumstances. However, we can draw some generalisations. It is particularly beneficial to hold REITs inside a tax-free investment because there is effectively no corporate or individual tax on the investment returns. So, if your
primary motivation for investing is to maximise your tax savings, you may want to consider including listed property in your tax-free investment. However, this choice is dependent on many other factors as well – not least whether it is suitable for your overall portfolio. While it may seem like holding cash in a tax-free investment is also very attractive, it may in fact be the least appropriate asset class to choose over the long term. The primary concern of investing in cash is that it earns lower returns over the longer term than the 6% to 8% annual real returns provided by equities and listed property. The tax-free returns on these longer-term investments, re-invested and compounded over many years, will likely be much more powerful than cash. At Prudential, we offer a range of tax-free unit trusts to suit a variety of risk and return requirements.
