What is a Tax Free Investment?

When it comes to investing, a tax free investment is one of the most powerful tools you can add to your investment plan, especially if you are young. Your tax free investment needs to be handled in the right way though in order for it to be most beneficial to you.

An explanation of tax free investing often leaves people’s eyes glazed or narrowed. So let’s demystify it for you.

What is a tax free investment?

A tax free investment is an investment or saving vehicle without any tax liabilities (dividends, interest or capital gains). Now don’t freak out if these terms already give you the heeby jeebies.

You know how SARS always takes a cut of your taxable income? The same things happens with investments. They take a cut either while it’s growing or at the end when you need to use it. That’s why tax free investments are like a VIP party for your money that SARS will never get an invite to. They will never be allowed at this party. IF you follow the rules.

This means, you never pay tax on the interest earned, dividends received, and capital gains within your tax free investment or when you need to withdraw from it one day. That’s right, no tax. No. Tax. At. Allllll. Can you say heck yeah!? Treasury did a great thing for South Africans by introducing this savings vehicle in 2015.

So why don’t I invest everything in a tax free investment? Well wouldn’t that be nice! However there are certain rules we need to abide by.

How much can I invest in a tax free investment?

You can contribute up to R33 000 per year, and up to R500 000 in your lifetime. The sooner you do this in your lifetime, the more you will benefit from compound interest over time.

For instance, if you started investing from the age of 21, and you invested R2 750 every month for roughly 15.2 years (until you get to your R500 000 lifetime contribution). Thereafter from age 36 onwards you never save a cent again, and by the time you are 65 you could reliably expect to be able to draw an income of R33 000 per month without ever running out of money in today’s value. Now that is just epic and really shows the wonder of compound interest. * (see assumptions below).

Can I withdraw money from a tax free investment?

Yes, but you want to only do this at retirement. Where tax free investments really shine is when they are left alone to grow and earn compound interest over time. We like to call it your “never touch money”. So using a tax free investment for a short term goal is not using this vehicle for it’s true purpose: long term savings.

We understand that sometimes life happens and you may need to use money saved in your tax free investment. Bear in mind though that withdrawals are not deducted from your overall contributions. Once you take that money out, it can never be replaced. The value of your savings may increase, but your contribution allowance is set. So try to avoid touching your “never touch money”.

Can you lose money in a tax free investment?

A tax free investment allows you to invest in all the same asset classes as any other investment vehicle, therefore the same principles apply. When you invest, you invariably take on some level of risk. Risk is defined as volatility, and different assets classes will have different levels of volatility.

For example, if you mostly invest in equities with your tax free investment, then it’s possible the value of your shares may decrease in the short term. In other words, the value of your shares will bounce around.

As another example, if you invest in cash and bonds your investment won’t be very bouncy (less risky over the short term), but it also won’t have very much growth in the long term.

Historically, equities outperform in the long term, and seeing that tax free investments are designed for long term investing, short term volatility shouldn’t worry you at all.

In fact, when the market is down and your units have lost value, but you are investing long term, you should be celebrating and buying more units (within your contribution limits) while they are still less expensive to buy. Your shares are on sale girlfriend!

What is key here is diversification within your tax free investment, but also across your whole investment portfolio. The best solution here is to talk to a financial planner about the appropriate asset allocation for your investment time horizon.

Can I have more than one tax free investment account?

You can, but your contribution limits still apply. R33 000 per year and R500 000 lifetime limit per individual South African citizen. You are allowed to move amounts between TFI accounts; this will not be seen as a new contribution.

For instance, if you started a TFI with one company and then decided to move it to another, you will not be penalised for this. It is up to you as the investor to keep count of your overall contributions. If you go over the limit, you will be taxed at 40% of your contributions above the annual limit.

What’s better, a tax free investment or a retirement annuity?

The answer to this depends on a number of factors, like your age, type of income you are earning and the tax structure you are currently on. There is no one size fits all answer for this question.

If you are not earning an income, then a tax free investment is way more beneficial than a retirement annuity, as you can invest in 100% equities over a long period of time. So if you are a stay at home parent, this might be a good option for you.

Generally speaking, a tax free investment can be a powerful complementary tool in investment planning.

Let’s use an analogy. Imagine two baskets. The basket on the left is labelled a Retirement Annuity, and the basket on the right is labelled a Tax Free Investment.

In the unit trust basket, you are only allowed to put very specific things in it, for example certain amounts of cheese, bread, fruit and sweets. And you’ll get certain rewards for doing this. In the Tax free Investment basket, you can have anything you want. You can have just fruit, or (more excitingly) JUST sweets, for instance. The rewards for doing this are realised long term.

A tax free investment (also often called a Tax Free Savings Account) is your chance to get a bit creative with your investment plan. It is a vehicle that allows you to invest, and you won’t ever pay tax on the interest earned on those savings.

Can I use a tax free investment to save for my children?

You can start a tax free investment in your child's name, but think very carefully about the future of this vehicle. Remember that any contributions to an account in their name will count towards their overall lifetime contribution limit.

For example, if you were to max out their lifetime contribution, and they decide when they turn 18 to spend the entire lump sum, they will not be able to contribute any more to their tax free investment going forward. Or if you decide to use it as a vehicle for saving for their education, once again you would be eating into their lifetime contribution limit.

Here’s another exciting example of what a TFI can do over time. Say you find out you’re having a baby. You take the next few months to save R33 000 and when your baby arrives you invest that money in a TFI in your baby’s name. So that’s a once off investment of R33 000. That money is left to grow and compound for 60 years, so by the time your child hits retirement, we can reliably predict that they can live off R30 000 per month (inflation adjusted) without ever running out of money. ** see assumptions

AMAZING!

What’s the best performing fund with the best returns?

The answer to this lies in understanding a number of factors: active versus passively managed funds, fees, and diversification.

An actively managed fund means that some super smart people are paid a lot of money to make decisions about where to invest their clients' money that will result in the biggest growth. These types of funds are generally more expensive to invest in because of it’s actively managed nature.

An Exchange Traded Fund (ETF) is a fund that tracks a certain index, for example the USAs S&P500 ETF. This tracks the 500 largest and most liquid companies listed on stock exchanges in the USA. The maintenance of these funds is generally minimal, and therefore much cheaper to invest in. Lower fees means more for the investor to keep.

Warren Buffet famously made a 1 million dollar wager that an index fund would beat a collection of actively managed hedge funds over a period of 10 years from 2007 to 2017. And he won that bet.

Why? Because the cost to invest in a fund/s can make or break your growth in the long term. This cost has a few names: the EAC (effective annual cost), the TER (total expense ratio) or the TIC (total investment cost). Whatever you want to call it, it’s a killer when it comes to growth.

The EAC for most investors in South Africa is sitting at around 3%. That may not look like much to you, but a 3 % fee would reduce the value of an investment by more than 40% over a 30 year period. Your fees should be below 1%.

If your investment did 9% in the last 5 years, and inflation is sitting at roughly 6%, that’s about 3% growth. Well that’s better than nothing you say. Ha! Silly billy, you haven’t taken into account the fees. If your fees are sitting at 3%, that leaves you with a big fat 0% growth. YUK.

By law, every financial institution governed by the FSCA should be able to tell you your EAC. So do yourself a massive favour and find that out and take action.

Can I trade in a tax free investment?

Yes you can. But let’s be clear about what trading is, and how it differs to investing. Trading is short term speculation where you try to time the market. You buy low and sell high. In other words you are taking a VERY active approach, and because you are a mere mortal and (almost certainly) cannot see into the future this can go horribly wrong. In short, we don’t like trading.

Investing takes the long game. Investors buy shares and hold them for a long time . They invest in companies that are on track for long term growth and value.

Where is the best tax free savings account in South Africa?

This depends on a few factors. But generally speaking, if you are investing for more than 10 years then you will want to work with a company who has access to global equity markets using ETFs and who champions low fees (the cost to invest on their platform). Perhaps the cheapest DIY option in South Africa right now is Easy Equities. This can however be intimidating if you’re a first time or novice investor. If you need help, we work with some great companies who reflect our core values and principles when it comes to tax free investing. Hit the button below to organise a consultation.

Assumptions:

Equity growth (including dividends) = 15% per annum. This is historically accurate

Inflation at 6%

Drawdown at 5%

Please note: This article does not constitute as financial advice. Should you require assistance, please get in touch to consult a licensed financial planner.