What you may not have known about Tax-free Investments
We have all had our moments where we were convinced that our opinion on a particular subject was absolute, and no one or nothing could convince us of anything else… until we were proven wrong. For years as a young boy, I believed that the title of ABBA’s hit song, “Take a chance”, actually read “Jackie Chan”. I sang my heart out: “If you change your mind, Jackie Chan, I’m the first in line, Jackie Chan”. Many years later, and much to my embarrassment, I found out that my version of the ABBA hit was completely wrong and that the actual title was “Take a chance”.
People often make the same mistakes when it comes to investments. They only hear snippets from a “song” and then proclaim their version to be the absolute truth. With this in mind, let’s take a look at one of South Africa’s latest investment hits, the tax-free investment, and how investors don’t quite have the lyrics down just yet.
“I don’t like to be restricted. What if I’m not happy with my financial provider in a year or so?”
When tax-free investments were launched in March 2015, this person’s concern would have been more than valid, because you were unable to transfer your tax-free investment to another provider.
Since 1 March 2018, however, regulation has become more flexible, allowing investors to transfer either the full tax-free investment, or a portion thereof to another financial services provider or providers (limited to a maximum of 2 transfers per year), without losing any of their benefits. This means that if another financial provider offers you the same investment option at a better price or product offering, you are free to switch all or part of your investment to that provider.
“I don’t plan to sell anyway. Aside from no CGT, the product doesn’t really offer any other benefits.”
This investor couldn’t be more wrong. Yes, tax-free investments are exempt from capital gains tax (CGT), but those aren’t the only words to the song. Whether you buy with the intention to sell or not, the benefits of tax-free investments do not end with CGT. You also do not pay any income tax or dividend withholding tax (DWT) over the entire span of this investment’s lifetime, and those benefits are bigger than investors may think.
As an example, let’s suggest that investors A and B both invested R33 000 (the current allowed annual maximum contribution to a tax-free investment, and R500 000 maximum contribution in total per lifetime) per year over a period of 15 years in a tax-free investment. Investor A’s personal income tax rate is 28% and person B’s personal income tax rate is the maximum of 45%.
To illustrate the benefits of the exemption of DWT, let’s suggest that both investors invested the full amount each year in the FTSE/JSE All Share Index (JSE). The total average returns on the JSE over the last 15 years, was 17% per year. Of this 17%, 3% in returns came from dividends, which means that at the current DWT rate of 20%, you could have earned an additional 0.6% per year in returns if you had followed the tax-free investment route.
To illustrate the income tax benefits of this product, let’s suggest that both investors A and B invested the full R33 000 per year in the FTSE/JSE SA Property Index (SAPY) over the same 15-year period. If they had done so directly 15 years ago (by applying current tax legislation), investor A would have earned (after his/her income on interest were taxed) R35 600 less, while investor B would have earned R57 200 less. Percentage-wise, based on the total original contribution of R495 000 over this 15-year period, investor A would have earned 7.2% less on his/her investment, and investor B would have earned a whopping 11.6% less.
“CGT doesn’t make such a huge difference when considering the bigger picture.”
Investors who believe this, aren’t only getting the words wrong, but are completely out of tune. CGT makes a massive difference. Let’s use the example of investors A and B again, their respective personal income tax rates, and the growth earned on the FTSE/JSE All Share Index over the last 15 years.
Take note that tax-free investments were not available 15 years ago, and if both investors invested their annual
R33 000 in the JSE, their investments would have grown to more than R1.6 million in total after 15 years. The problem is that that by applying current tax legislation, if they needed to sell, investor A would have paid R127 000 (8% of investment total) in CGT, while investor B would have paid R204 000 (13% of investment total) in CGT. If tax-free investments were available 15 years ago, they would have been able to sidestep the entire CGT charge today, so clearly the difference is very big.
As with any financial product, it’s always important to do your homework and to make 100% sure that the product you choose will satisfy all of your investment needs. I believe that tax-free investments will remain one of those investment hits that will keep investors singing along for many years to come. If you are one of them, just make sure that you know the (right) words to the song.
The opinions expressed in this blog are the opinions of the writer and not necessarily those of PSG. These opinions do not constitute advice. This is intended as general information and does not form part of any financial, tax, legal or investment related advice. Although the utmost care has been taken in the research and preparation of this blog, no responsibility can be taken for actions taken based on the information contained herein. Since individual needs and risk profiles differ, it is always advisable to consult a qualified financial adviser before taking action.
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