Investment returns serve as the fundamental metric by which to measure performance. Whether invested in equities, bonds, property or alternatives, people become fixated on the percentage growth of their money. However, many people do not consider the material manner in which these returns are compromised by poor tax planning. Essentially, certain investment vehicles are more tax-friendly than others, while some come with certain restraints, such as liquidity clauses and maximum lifetime contributions.
Unit trusts are one of the most common and well-known investment vehicles in the market. They are highly flexible in that they are not confined to any regulation regarding their underlying asset allocation. Furthermore, these investments are fully liquid, with the proceeds from the redemption returned to the investor within five working days from submission. However, this flexibility and liquidity comes with a drawback in terms of a lack of tax efficiency (for those with a higher average tax rate).
A capital gains event is triggered where you decide to sell or switch part or all of your investments (units in a unit trust). Currently, 40% of any capital gain is included in your annual income; this equates to a capital gains tax (CGT) rate of 18% for individuals paying the maximum 45% marginal tax rate. Also, note that each individual is allowed a R40,000 annual capital gain exclusion. As a simple example, suppose an individual with a marginal tax rate of 45% invests R1,000,000 into a unit trust. The investment then grows to R1,500,000. At this point, the investor decides to terminate the investment. The CGT payable by the individual would be R82,800 (growth less the R40,000 exclusion, multiplied by 18%.) Therefore, the individual's real profit on the investment of R1,000,000 would be R417,200.
Tax-free savings accounts
Tax-free savings accounts (TFSA) allow you to invest without paying any tax on the growth (capital gains, interest or dividends) of the investment. Individuals are permitted to contribute R36,000 per tax year, up to a lifetime limit of R500,000, into a tax-free savings account. Generally, TFSA's are best suited to long-term investments so that the tax benefits compound over time. Furthermore, it is important to remember that this annual or lifetime contribution does not "reset". For example, if you put R36,000 into a TFSA at the beginning of the tax year but then withdraw R20,000 from this investment vehicle three months later, you will be unable to make further contributions until the start of the next tax year.
TFSA's are great savings vehicles for young people starting their investment journeys. Aim to max out the R36,000 allowable annual contribution. Remember, you can do this by way of a single lump-sum contribution or by smaller amounts on an ad-hoc basis. You can also achieve this by starting a R3,000 monthly debit order at the start of the tax year.
Retirement annuities (RA's) are tax-efficient investment products used by individuals to save for retirement either when an employer does not provide a pension fund, or when they wish to maximise allowable deductions by saving more than the amount contributed by the employer. The incentive to save using a retirement annuity lies in the fact that any contributions, up to the lower of 27.5% of your gross income or R350 000, are tax-deductible. The amount contributed to the retirement annuity reduces your taxable income for the year.
Any capital gains, dividends or interest income received within the product are not taxed. Switches between funds within a retirement annuity are also free from tax, thus enhancing the overall flexibility of the investment.
Although the growth within a retirement annuity is not subject to tax, withdrawing from one is (to an extent). When retireing, individuals can make one tax-free lump-sum withdrawal up to the lower of R500,000 or one-third of the total value (there is a discrete tax table used to calculate the tax on lump sum withdrawals above R500 000). The remainder must be transferred to a compulsory living annuity, where an annual drawdown rate of between 2.50% and 17.50% is set to sustain your income needs during retirement; the income is taxable.
Retirement annuities are subject to Regulation 28, limiting the extent to which retirement funds may invest in a particular asset or asset class. Although this is for protection purposes, it may come at the expense of growth within the portfolio.
Endowment policies are tax-efficient investment options for individuals with an average tax rate greater than 30%. These investments are subject to liquidity constraints during the first five years (the restricted period), during which time investors are allowed one interest-free loan and one surrender of the policy, limited to capital invested plus 5% per annum. After the restricted period, the endowment becomes fully liquid, allowing for ad hoc and regular withdrawals.
"Ensuring that your investments are structured tax-efficiently is arguably just as important as their performance."
Offshore endowments tend to differ slightly in their liquidity and offer multiple surrenders during the initial five-year period. This provides the investor with the benefit of extra liquidity during the initial five-year restricted period. Interest income within an endowment is taxed at 30% instead of 45% for top income earners, and capital gains are taxed at an effective rate of 12% instead of 18% for investors in the highest tax bracket.
Ensuring that your investments are structured tax-efficiently is arguably just as important as their performance. Getting the balance right between tax efficiency, liquidity and flexibility of the underlying assets is the key to a successful investment portfolio that can help fund your retirement, pay for that overseas holiday, or pay for your child's education. Always seek advice and consider the tax implications when looking to invest your hard-earned money.
This article features in the Nov / Dec 2021 edition of the Proficio, NFB's bi-monthly financial update newsletter. Download the complete newsletter here.