While the tax benefits of tax-free investments are indisputable, a tax-free investment should be viewed as part of your overall investment portfolio to ensure that it is achieving its purpose. Here are 10 ways to ensure your tax-free investment works for you.
Utilise your available tax-free savings: Tax-free investments provide tax benefits in that all the growth and income received on the investment are tax-free. This means that you are not liable for any capital gains tax, dividends withholding tax or tax on the interest received. However, keep in mind that your contributions towards your tax-free investment are made with after-tax money meaning that no tax deduction is available on your contributions (as is the case of retirement fund contributions). With this in mind, it makes sense for investors to first ensure that they’re contributing adequately to a retirement fund to minimise their taxable income before setting up a tax-free investment.
Think long-term: The tax benefits achieved by investing in tax-free investments are not realised early on which means that these vehicles do not make good emergency funds. The value of the tax benefit in the first five years of investing is incredibly small, with investment returns and tax savings only become meaningful after about ten years. As such, it is advisable for investors to take a long-term view when setting up a tax-free investment. Although tax-free investments are not necessarily intended as retirement funding vehicles, you can use yours to supplement your retirement savings. However, should you be earning below the tax threshold (i.e. you do not pay tax on your income) they do make very effective investment vehicles to build wealth over the long term.
Automate your investment: Legislation allows you to invest up to R36 000 per year (or R3 000 per month) towards a tax-free investment with the maximum lifetime contribution being R500 000. Most product providers make allowance for a minimum monthly contribution of R500 with the option of making monthly or annual contributions, or even ad hoc contributions as and when the opportunity arises. Depending on the nature of your earnings, set up a debit order or payment system for your tax-free investment that works for you. For instance, if you are a commission earner, you may want to contribute a smaller monthly amount via debit order with the option of making ad hoc contributions as and when affordability allows.
Avoid premature withdrawals: Legislation permits you to withdraw from your tax-free investment at any time, but it is important to first understand the implications of doing so. Any withdrawal made from your account is deducted from your lifetime contribution. For instance, if you have contributed a total of R300 000 towards your account and you withdraw R50 000, you will still only have R200 000 lifetime contribution available to you. In other words, you can’t top up your account again after a withdrawal, and any withdrawal will result in you forfeiting your tax benefits while at the same time wasting part of your lifetime contribution and losing out on potential investment returns.
Align your investment with your goals: When setting up your tax-free investment, give careful thought to how you intend to use the proceeds and then choose an investment portfolio that is aligned with your horizon. For instance, you may wish to use it as a savings vehicle for your newborn child’s tertiary education, in which case your investment horizon is approximately 18 years. On the other hand, if you want to use it to supplement your retirement funding, you may be looking at a longer time period. Either way, if you’ve taken a long-term view on your tax-free investment, consider having a higher allocation to growth assets and less allocation to cash and fixed income which are poor long-term investments. On this note, remember that if you are under the age of 65, you receive an annual tax exemption of R23 800 per year on all interest income, while from the age of 65, this exemption increases to R34 500. Assuming you receive an annual interest rate on your savings of 5%, you would need to have at least R476 000 under the age of 65, and R690 000 over the age of 65, in your TFSA before you receive a single Rand of tax benefit by using a TFSA for interest-bearing investments. Therefore, your TFSA will only really start working in your favour if you target the growth asset classes which underlying assets pay dividends or trigger capital gains tax which you are now exempted from in your TFSA.
Invest on a reputable platform: Most reputable investment platforms offer a wide array of local and offshore funds to choose from, meaning that you can construct a portfolio that meets your specific investment goals. While you also have the option to invest in a money market or fixed-term bank account, it is likely that your tax-free investment will achieve more favourable returns over the long term if housed in a more aggressive unit trust portfolio. Importantly, consider choosing an investment platform that can provide a holistic overview of all your investments, including your retirement annuities and discretionary investments. While you are able to transfer your tax-free investment from one provider to another, remember that the transfer can only take place between service providers. Importantly, note that you cannot withdraw your funds from one tax tax-free investment and deposit them into a new one, as such action would be viewed as a withdrawal and reinvestment that would count toward your lifetime allowance.
Avoid over-contributing: If you contribute more than your annual allowable amount of R36 000, keep in mind that contributions on the amount above the annual allowance will be taxed at a flat rate of 40% regardless of your personal income tax rate. This is a risk, especially if you are contributing towards multiple tax-free investments.
As a final word, although no tax is payable on the earnings within a tax-free investment, as a South African tax resident you are required to disclose all investment information to SARS when submitting your annual tax return, including certificates issued for income within your investment.
Have an amazing day.
Sue
