Did you know that the tax efficiency of your investments can greatly benefit your long-term investment outcomes? That is because avoiding tax leakage significantly enhances the compounding effect of an investment over time, says Naledi Makiwane, investment specialist at Coronation Fund Managers.
For individual investors in South Africa, there are various solutions aimed at encouraging you to invest for the long-term while enabling tax-efficient capital build-up.
Makiwane shares three tax-efficient investment solutions you can consider to help you grow your wealth over time:
RETIREMENT ANNUITIES
A retirement annuity (RA) is an ideal way to supplement your existing pension or provident fund if you are permanently employed, or to build a retirement nest egg if you are self-employed. When investing in an RA, you can choose to make either lump sum or regular monthly contributions.
The attraction of an RA is that its tax efficiency kicks in from day one – you get an immediate tax break on any contributions that you make (within certain limits). In addition, any investment growth (that would usually be taxed) such as interest, net rental income, and local and foreign dividends are free from local tax while your assets remain invested.
You can access your RA investment any time after you turn 55, or earlier if you are permanently unable to continue working due to injury or illness. When you retire from the fund, you can elect to receive a maximum one third in cash and place the remaining two thirds in a post-retirement annuity, which can be either a living or guaranteed annuity. Note that your post-retirement lump sum and income payments are taxable (although you may qualify for lump sum tax concessions and benefit from a lower average tax rate).
TAX FREE INVESTMENTS
All South African residents are eligible to invest in a tax-free investment (TFI), including minors. You can invest up to R36 000 per tax year and a total of R500 000 over a lifetime. Just remember not to contribute more than the annual or lifetime limits, as any excess contribution will be taxed at a rate of 40%.
With a TFI you don’t pay any local tax on your investment returns (i.e. interest or other income, dividends, or capital gains) both for the duration of your investment and when the investment pays out. As with an RA, the taxes you save remain invested, compounding year after year which can make an enormous difference to your total investment.
Imagine that you invest the maximum annual amount (R36 000) in a TFI for your child from birth. If you continue doing so, you will reach the lifetime contribution limit of R500 000 before your child turns 14. The longer you decide to keep the money invested, the more pronounced the benefits of compounding and the greater the extent to which your TFI outperforms the same taxable fund as demonstrated below.
It is also advisable to resist the temptation to use your tax-free investment as an emergency fund. While you have unrestricted access to your money, it is important to note that once you withdraw, you cannot replace that amount as all contributions count towards your lifetime limit of R500 000. Withdrawing frequently will only erode your potential long-term capital growth.
ENDOWMENTS
An endowment is an investment plan that allows you to create wealth tax-efficiently. It benefits investors with a marginal tax rate greater than 30% and a minimum investment time horizon of five years. While the investor’s access to their capital is limited in the first five years, taxable growth such as interest, net rental income, dividends and capital gains, is taxed within the plan, which means that there is no additional tax payable when one withdraws the proceeds. The appeal of this product is the flat tax rate (30%) on taxable growth and 12% tax on capital gains (compared to effective rates of 45% and 18% respectively for individuals in the highest income bracket). To avoid liquidity constraints, limits apply to your contribution to an existing endowment after Year One (as detailed below). It may be advisable to speak to your financial advisor about how to structure your endowments.
