Investing tax free

22 June 2015

It is a known fact that if you want to grow your wealth effectively, and ensure you are prepared for future financial needs, you need to save and invest for these goals in a manner that best meets your individual needs and circumstances.

On 1 March 2015, National Treasury introduced the long awaited tax-free savings accounts – or TFSAs - which aim to improve the savings culture in South Africa. It is clear that Individual Savings Accounts (ISAs), available to UK residents since 1999, have had a major influence on the local tax legislation and the regulations that govern tax-free savings accounts.

ISAs have proven to be very effective to encourage savings and investments in the UK with the annual contribution limit currently set at £15 240 (about R275 000). The ISA season falls between the end of March and early April each year. The market value of adult ISA holdings stood at £470 billion at the end of the 2013-2014 UK tax year.

South African resident taxpayers can now invest up to R30 000 during any year of assessment in tax-free savings accounts. The proceeds from these investments will not attract any income tax, dividend withholding tax or capital gains tax. The lifetime contribution limit is currently set at R500 000. It is, however, important to note that the limits relate to all tax-free savings accounts and that any excess amount will be subject to a tax penalty for the year of assessment during which the limit is exceeded.

While tax-free savings accounts offer liquidity, amounts withdrawn and reinvested during a year of assessment will form part of your annual contribution limit. Amounts that have been withdrawn and which cannot be replaced, either due to reaching the annual contribution limit or not utilising the limit during the year it was withdrawn, reduce an individual’s lifetime contribution limit.

The products that qualify for tax-free savings are also limited and include most unit trusts, exchange traded funds, savings accounts (not transactional), fixed deposits and RSA Retail Savings Bonds. These are not new products, but investment returns will be treated differently by the South African Revenue Services if they are classified as tax-free savings by product providers. Product providers include banks, long-term insurers, managers of collective investment schemes, the government, mutual banks, co-operative banks and linked investment service providers.

The regulations exclude structured products, direct investments into shares, products that alter the return profile to the client, products that charge a performance fee and fees/penalties that may be charged on withdrawals from products with a guaranteed return or fixed term.

In terms of current legislation, existing investments cannot be converted to tax- free savings accounts.

As a result of the contribution limits and due to the effect of compounded growth, tax-free savings accounts should be considered for long-term investing in order to really benefit from the tax-free returns that will be accumulated. It will take approximately 17 years of maximum annual contributions before you reach the current lifetime limit and withdrawals cannot be replaced through additional contributions.

The new tax-free savings accounts are, however, not the only tax efficient means  of investing. The current interest exemption of R23 800 is still available to taxpayers under the age of 65 (R34 500 if you are over 65) and an interest bearing investment may be more appropriate for short-term contingencies. The first R30 000 of a taxpayer’s capital gains during a year of assessment is also exempt from capital gains tax. As a general rule, an emergency fund equal to three months’ worth of expenses should be built up and a tax-free savings account may not be the ideal vehicle for this.

It must also be noted that the use of an appropriate short-term tax efficient vehicle should not only be driven by the extent of the tax benefit, but also by the need to save for a short-term goal and the risk appetite of the investor

There is a point where expected additional returns (due to the more risky nature of an investment) compensate the investor for potential tax savings.

Depending on your individual needs and circumstances, and speaking in general terms, a discretionary investment where you can make use of your tax exemptions should be among your considerations when looking at solutions for savings and investments.

After making provision for short-term contingencies, investors may want to consider a retirement annuity fund. Similar to tax-free savings accounts, investment returns in retirement annuities attract no income tax, dividend withholding tax or capital gains tax. Contributions to a retirement annuity are tax deductible up to a maximum of 15% of non-retirement funding income and further enhance  the tax efficiency of the investment. The tax refund, which could be as much as 41% (depending on your tax rate), can be reinvested in the retirement annuity or other tax efficient vehicle to further enhance your tax benefit. There are other benefits and restrictions which are best discussed with your financial advisor.

Retirement annuities are subject to Regulation 28 of the Pension Funds Act which places limits on the asset allocation with which the investment must comply. Broadly speaking, these specify a maximum of 75% to local equities, 25% to local property and 25% to foreign investments.

Endowment policies issued by long-term insurers only offer a marginal tax benefit to taxpayers with a high tax rate since tax on investment returns is deducted from the investment by the insurer at flat rates. For this reason, endowment policies as a tax efficient vehicle should be considered after the use of other tax efficient investments have been maximised.

Depending on your individual needs and circumstances, and speaking in general terms, a discretionary investment where you can make use of your tax exemptions should be among your considerations when looking at solutions for savings and investments.

What remains extremely important, regardless of the relative tax efficiency of the investment vehicle(s) you choose, is that all the alternatives mentioned above are useful mechanisms to assist you in making sufficient provision for financial emergencies and retirement.

Ashburton Investor Services offers the Ashburton Investment Account which can be used for short-term savings; the Ashburton Endowment for medium- to long-term saving; the Ashburton Retirement Annuity Fund for long-term retirement saving; and the Ashburton Tax Free Savings Account.