Tax free sounds good to me
As things currently stand the only accounts that allow you to earn investment returns free from the clutches of the South African Revenue Services are retirement vehicles (Retirement Annuities, Pension Funds, Provident Funds and Preservation funds).
However, the SA Treasury is planning to launch what is being called a ‘tax incentivised savings account’ which will allow you to save and invest tax-free outside of retirement products. I am sure there will be a much smarter name for them by the time they arrive but you would do well to start thinking about how best you can use them to maximise your financial wellbeing in the future.
To this end I provide some insight into the basic structure of the new accounts and potential ways of incorporating them into your future investment strategy and financial planning process.
Key Features :
Should be available to South African residents from 01 March 2015.
All returns within this account will be tax free, including dividend withholding tax.
Contributions to the account will be limited to R30 000 per year – this number is likely to increase with inflation over time. If you do not use the allowance one year you cannot carry it over to the next year.
Contributions to the account will be subject to a ‘lifetime limit’ of R500 000 per individual – that’s about 16 years worth of contributions if the annual limit remains at R30 000.
Any money withdrawn from these accounts will still count towards your lifetime limit – So if you contribute R300 000 then withdraw R100 000, you will still only be able to contribute another R200 000 over the remainder of your lifetime. This feature is designed to keep individuals from dipping into their savings for impulse buys and the like.
You will be able to invest in a variety of asset classes including; bank deposits, RSA retail bonds, ETF’s and other collective investments. At this stage it is envisaged that dealing in individual shares will NOT be permitted within these accounts. The idea behind this move is to discourage speculation and to promote long-term investment and savings behaviour.
An individual will be able to open up two of these accounts per year as long as they stay within the R30 000 annual contribution limit. This exists so that you can split a portion of the allowance into an interest bearing account, like at the bank, and a portion into investments which offer capital growth potential, like an equity ETF.
Higher compounded investment returns: Tax free returns can significantly boost the future value of your investment portfolio as it allows a greater proportion of your nominal investment return to be reinvested and therefore compounded over time.
Higher tax free income: This account will boost the potential for greater tax free income both before and after retirement (See our simple case study below). Individual rebates, retirement funding allowances, interest income allowances and now these tax free savings accounts can be combined to significantly enhance the tax efficiency of your overall financial plan. Even for the ‘wealthy’, the R30 000 annual allowances may not sound like much but they will compound over time and are likely to result in meaningful investment portfolio’s over the long-term.
Trading strategies are more attractive – If your investment strategy requires more frequent rebalancing, these accounts can help circumvent the trading gains and even future capital gains implications over time. Note this is not to suggest speculative activities are encouraged in an investment account.
Life cycle planning opportunities– One can use these account’s differently depending on the stage of your life when trying to minimise the greatest tax burden. Before retirement you may find investing in higher growth assets (like equity ETF’s) is useful in this type of account to maximise your final portfolio value. When you enter retirement you may want to switch the focus to interest bearing assets in this account so as to maximise the after tax yield on your fixed income investment allocation.
Asset Allocation decisions – Capital gains tax is lower than income tax and dividends withholding tax, so if you plan on investing in a multi-asset portfolio for longer than the 3-year horizon (the generally accepted time period to hold an asset for gains to be recognised as capital in nature) you may want to keep assets that will attract capital gains tax in a separate investment account. You can then potentially reserve the tax free account allocation for income producing assets, such as property or bonds, which are likely to incur the higher income tax charge.
Practical case study:
Two individuals, J and Z, are keen to get their investment portfolios going. They both decide to make annual R30 000 investment contributions, paid in full at the start of each year, for the next 16 years. They both expect to receive a handsome annual return of 15% after fees and they both have a marginal tax rate of 35%. (We’ll assume all of their returns would be taxable at the marginal rate). J opts to use Treasury’s new tax incentivised savings account, while Z thinks it’s a waste of time and opts to invest in a normal investment account at his broker.
After 16 years the value of the J’s tax free portfolio would be a little over R2.2 million versus Z’s portfolio (which incurs tax) which would only be worth around R1.29 million. That means J now has an additional R911 000 in his account after the 16 year period purely as a result of using the tax free account.
Now suppose J and Z reach retirement and both want to use their funds to provide an additional income. As we have seen above, J’s account will have a much higher value as a starting point but very importantly the income generated from this account will remain tax free, whereas any income from Z’s portfolio will continue to be taxed at the individuals marginal tax rate.(Probably a lower rate in retirement – let’s say 25%)
If we assume that J and Z’s lump sum investments can earn 8.25% a year in income and that all deductions and allowances have been used so that the income from these two options is taxable at the individual’s marginal tax rate -What would the monthly incomes be for the two?
That’s right, J continues to enjoy tax free returns and is now earning more than twice the monthly income relative to Z who essentially did everything identical in terms of investment strategy but he just used a different (taxable) investment vehicle.
The above example may be simple but it captures the essence of the opportunity that these new accounts represent.
I lived in the UK for almost 9 years, where they have operated similar products (Individual Savings Account’s or ISA’s) for some time now and can say from experience that this type of account will potentially provide a big boost to your financial planning armoury over the long run.
If you start putting some money aside now you will be ready to contribute the full amount by March next year and ensure that you maximise the opportunity to compound your TAX-FREE returns in full from day one.
If you have any questions or want further advice on how to structure your investments or improve your personal finances please contact us at email@example.com