Moneyweb received the following question from a reader:
I have a question around saving for an unborn child’s education. I thought an endowment would be a good idea, but my fiancé thought we should use a tax-free savings account. Also how much should we be putting away each month? I was thinking R800 to R1 000 – is that a useful amount? Also, when should we start saving?
Mduduzi Luthuli, head of wealth management at Luthuli Capital, answered the question:
I’m glad you’ve made the decision to start saving early for your child’s education. One of the greatest assets one has when building a portfolio is time. The longer your funds are saved, the greater the exponential growth effect of the compound interest earned. What does this mean, it just means that the longer you save, the greater the potential maturity value or growth on your initial capital as your interest earns interest on itself over the investment period and this can have a snowball effect with the correct investment strategy.
When should you start saving? The simple answer is as soon as you possibly can. It’s never about timing the market, but rather about the time you spend in the market. If you have disposable cash, invest it and let your money start growing into an asset that someday can hopefully pay you a passive income and assist you on the journey to financial independence. With the help of a wealth manager, your money can work for you.
In terms of how much one should invest, how much really is enough? This is a question you can approach from two directions. The first option is to try work out how much you’ll actually need for your child’s education and when you’ll need this amount. As an example, will you need R1 million in ten years’ time? If you’re unsure of the possible maturity value, sit with a wealth manager for assistance.
Say you’re saving for your unborn child’s high school career. A wealth manager will look at the current cost of attending high school. You’ll advise them of the type of school you’d like your child to attend, they will take the current real cost over five years (tuition, uniform, travel, food, etc.) and then do a projection calculation to tell you how much you might need when your child needs to attend high school. Using the example stated earlier of R1 million, this projection calculation looks to work out what the equivalent of R1 million today will be in 12 to 13 years’ time when your child attends high school. Remember inflation erodes the buying power of money. All that means is that R1 million today won’t have the same buying power in 13 years’ time, let alone one years’ time. The current education cost inflation is estimated to be 10% p.a.
The second way to address this question of how much is enough is just by drafting a budget and working out how much you’re able to invest monthly without deteriorating your quality of life or standard of living. I always say to my clients, save as much as you possibly can, but this must not be to your detriment. You must be able to pay the bills, buy food, have shelter and go out with friends. Live your life. I have found that when an investment means your quality of life is sacrificed, most people grow to resent that investment which ultimately leads to them cancelling it and thus nullifying whatever objective it was meant to address. Save what you can and are comfortable with.
The most important thing is to start and actually begin to develop the habit of saving. A good wealth manager can help you draft a budget and also give you an indication of how much you would have saved by the maturity date of your investment. Always remember that a projection value is a just a very good estimate. Nobody knows how any market will perform over a decade or more. A projection is an educated guess based on assumptions. These assumptions are based on industry knowledge and indices so ask your wealth manager to explain these to you until you’re satisfied and comfortable with how the calculation is worked out. It was Einstein who said, “If you can’t explain it to a six-year-old, then you don’t understand it yourself.” Your wealth manager must explain it to you.
In answering your question, is an endowment a better vehicle than a tax-free savings account? This is a complicated question to answer because each vehicle serves a certain purpose. Let us rather aim to understand the characteristic of the two vehicles and hopefully this will guide you with regards to deciding which option best suits you. Endowments are best suited for higher income earners looking for an investment that will save them tax, provide growth strategy, and liquidity (access to the funds) is not a priority. Let’s unpack that statement because it actually contains a lot of information.
Endowments are taxed at a flat rate of 30% for individuals and trusts, which makes them attractive for investors with a marginal tax rate greater than 30%. This simply means that any interest income (investment growth) from the endowment would be taxed at 30%, as against the maximum marginal rate of 41% (maximum income tax paid) for individuals. This is why if you’re a high tax payer, an endowment may be considered as a means to reduce your tax burden whilst providing growth on your funds. If you’re not a high tax payer, you might be accepting an additional tax burden unnecessarily. This tax structure of an endowment also translates into lower capital gains tax of 10%, compared to the maximum rate of 13.33% for individuals. What is your marginal tax rate? On which side of the coin do you sit? For a tax-free savings account, the interest, capital gains and dividends you earn are completely tax free.
Endowment policies have a minimum five-year term (or restriction period). An endowment policy is legally required to have a minimum five-year term (also referred to as a restriction period as it restricts the withdrawals you may make from the policy). This applies to:
- The first five years of the policy, or
- Five years from the first day of any month during which the “120% rule” takes effect (see below).
- The 120% rule takes effect when your contributions in any policy year are greater than 120% of the higher of any of the previous two policy year’s total contributions. Your investment will accept these contributions into the same policy and extend the restriction period (if you are already in a restriction period) or start a new five year restriction period on the entire policy
If you will need access to the cash before a minimum investment period of five years, an endowment would not be the best choice. Trying to access these funds during the restriction will result in you being charged a termination fee which will reduce your investment value. If you plan to increase the monthly premiums by more than 20% per annum, the 120% rule just means that you’re extending the restriction period on your investment.
Whilst a tax-free savings account provides full liquidity, meaning you may access your funds at any time with no restrictions or termination fees, there is also a restriction on how much you may contribute to the tax-free savings account. You may contribute R30 000 maximum per year, subject to a lifetime maximum of R500 000. There is a 40% tax penalty on any amount you invest in excess of the maximum across product providers. For example, if you invest R35 000, which exceeds the annual limit by R5 000, 40% of the R5 000 excess (i.e. R2 000) must be paid to Sars at your tax assessment.
With all of the above said and considered; given your proposed R800 -R1 000 monthly investment, I would recommend the Tax-Free Savings Account as the maximum monthly premium is R2 500. Take advantage of the 0% tax on interest growth offered through this vehicle.