In most instances, tax is unavoidable – but it if you’re strategic about the construction of your investment portfolio, you can significantly reduce your tax liability and boost your investment returns. While government has put numerous incentives in place to encourage South Africans to save more, it is important that we fully understand how these incentives work in our broader investment portfolios to ensure that we minimum tax and generate the desired returns, while at the same time achieving our investment goals.
As investors, we have a wide range of products available to us which, if used optimally, can be employed to achieve our short-, medium- and longer-term savings goals. The tax implications of investing in unit trusts, endowments, retirement annuities or tax-free savings account are all different, and in order for the tax-efficiency to be maximised, it is always advisable to take a tactical approach to investment planning. That said, while tax efficiency is an important consideration, it is not the only factor that should be taken into account when building your portfolio. Your propensity for investment risk, your investment horizon, the types of returns required to achieve your goals, future liquidity problems, and what access you have to your capital are all important considerations in building your savings portfolio.
Your retirement annuity
Generally speaking, retirement funds offer the most in respect of tax efficiency because investors are able to invest with before-tax money. Contributions, including those made by an employer in respect of a group retirement fund, are tax deductible up to 27.5% of your taxable income, capped at R350 000 per year. In addition, investors do not pay capital gains tax, dividends withholding tax or income tax on the investment growth in a retirement fund, and this includes pension, provident and retirement annuity funds. It is important to note, however, that while the tax benefits of a retirement fund are particularly attractive, these funds are heavily regulated and, as an investor, it is important to be aware of the restrictions associated with retirement fund investing. In the first instance, all retirement funds are subject to Regulation 28 of the Pension Funds Act which aims to protect investors against poorly diversified investment portfolios by limiting equity exposure to 75%. Local or international property is limited to 25%, while foreign investment exposure is limited to 30%. There are also additional sub-limits for alternative investments and the percentage of a portfolio that can be held in offshore, amongst other restrictions.
When it comes to accessing capital held in pension and provident funds pre-retirement, you are only able to withdraw from these investments in the event of resignation or retrenchment from your employment.
When it comes to retirement annuities, you can only access these before you turn 55 if you become permanently disabled or if you financially emigrate from South Africa. What is important to keep in mind is that retirement funds are a life-long investment commitment because, at retirement, you are obliged to use these a minimum of 2/3rds of the funds to purchase an annuity income whether in the form of a life annuity, living annuity or combination of both. While some may view these restrictions as limiting from an investment perspective, retirement fund regulations are designed to prevent investors from dipping unnecessarily into their retirement nest eggs and to secure a better financial future.
From a tax perspective, if you choose to take a cash lump sum from your pension or provident fund on resignation or retrenchment, you will be taxed according to the following withdrawal table, cumulatively over your life-time:
Taxable income (R) Rate of tax (R)
1 – 25 000 0%
25 001 – 660 000 18% of taxable income above 25 000
660 001 – 990 000 114 300 + 27% of taxable income above 660 000
990 001 and above 203 400 + 36% of taxable income above 990 00
At retirement, should a portion be taken as cash up to a maximum of one-third, you will be taxed on the retirement tax tables cumulatively over your lifetime:
Taxable income (R) Rate of tax (R)
1 – 500 000 0% of taxable income
500 001 – 700 000 18% of taxable income above 500 000
700 001 – 1 050 000 36 000 + 27% of taxable income above 700 000
1 050 001 and above 130 500 + 36% of taxable income above 1 050 000
Your unit trust portfolio
While unit trust portfolios provide the most investment flexibility, they offer the least in respect of tax efficiency, with investors potentially being liable for income tax, capital gains tax and dividend withholding tax depending on how strategically the portfolio is managed. Local and foreign interest earned in a unit trust portfolio is taxed at your marginal tax rate, while both local and foreign dividends are subject to dividends withholding tax (DWT) of 20%, which is tax levied on dividends declared and paid by South African resident companies and foreign companies listed on the JSE. If you are under the age of 65, up to R23 800 of local interest is tax exempt, while for over 65s up to R34 500 is tax exempt. Further, when you switch between unit trusts or withdraw, you effectively trigger a capital gain or loss, and 40% of your capital gain will be taxed at your marginal tax rate with the first R40 000 per tax year being tax exempt.
If you have invested indirectly offshore through a rand-denominated fund, you will be liable for tax on all gains generated from either capital growth or currency movement, as well as tax on foreign interest and dividends at 20%. On the other hand, if you are invested directly through an offshore platform, unlike indirect offshore investments, no tax is paid on gains made as a result of currency movement.
A unit trust portfolio can play an important role in one’s discretionary portfolio when it comes to creating liquidity, diversifying one’s portfolio, saving for pre-determined goals, and investing more aggressively. However, it is important that you take into account the potential CGT consequences of selling or switching unit trusts so as to avoid unnecessary costs which can negatively impact on your investment returns.
Your tax-free savings account
Tax-free savings accounts (TFSAs) provide a great combination of tax efficiency and investor flexibility, although they should not be misinterpreted as being conducive for short-term savings. Because of the regulations that restrict your annual contribution limit and lifetime maximum limit, frequent withdrawals from a tax-free savings account will limit the power of compounding and affect your ability to save tax-free in the future. Like a unit trust portfolio, all contributions made to a TFSA are made with after-tax money.
However, the tax benefits of a TFSA lies in the fact that all interest and dividends generated in the TFSA are tax-free, and no CGT is paid on withdrawal, which means that your return potential in a TFSA is higher than in a standard unit trust. But, the amount that you can invest in a TFSA is limited – with your annual contributions restricted to a maximum of R36 000 per tax year into a TFSA, and a total lifetime contribution being capped. Any amount that exceeds these limits will be taxed at 40%, so it is important that TFSA investors monitor their contributions, particularly if they have multiple TFSAs in place. When it comes to investment choice, TFSAs offer a wide range of options with most life insurers, banks, unit trust companies and LISP platforms offering TFSA products.
Once again, while there are tax benefits for investing in a TFSA, be sure that you employ this type of savings vehicle as part of a broader investment strategy.
For instance, it may make sense to first maximise the tax benefits of contributing towards a retirement annuity and make use of your annual tax-free interest exemption of R23 800 per year, before taking out a tax-free saving.
Endowments also offer tax benefits to investors with a marginal tax rate of more than 30% as it will reduce the tax payable on investment growth. However, it is important to bear in mind that endowments have restricted investment terms of a minimum of five years although you can make one withdrawal during the restriction period, although this may be subject to penalties. Endowments are flexible in that investors can make lump-sum or recurring contributions towards their investments, with all contributions being made with after-tax money. Importantly, endowments are taxed in the hands of the life company at a fixed rate of 30%. This means that if an investor’s marginal tax rate if above 30%, an endowment effectively provides more tax-efficiency than a unit trust investment. From an estate planning perspective, investors can nominate beneficiaries to their endowment with the proceeds being payable immediately without having to wait for your estate to be wound up. That said, the proceeds of an endowment are considered deemed property in a deceased estate and are therefore estate dutiable. Depending on the investment platform you use, investors are not regulated in fund selection and can choose any combination of funds, with switches being allowed. Investors can also choose between local and offshore endowment, depending on their specific goals and objectives.
As is evident from the above, the interplay between tax and investment returns can be complex, and tax saving should not be the only goal to the exclusive of other objectives.