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Will tax-free savings accounts trump RAs?

If you have time on your side.

CAPE TOWN – From 1 March next year South Africans will have the chance to invest in tax-free savings accounts. While there has been a fair amount of talk about these accounts, little has been said about how best to use them.

Their introduction is definitely one of the most beneficial changes in savings regulations South Africa has seen in years. For anyone who is currently investing regularly into a unit trust or exchange-traded-fund (ETF), transferring as much of that contribution as possible into a tax-free account is a no-brainer, provided you can use the same or similar type of product.

Treasury has said that collective investments schemes – effectively unit trusts and ETFs – will qualify as tax-free savings accounts, although products that charge performance fees won’t be allowed. Funds may also not hold more than 10% of their portfolio in any single share or commodity.

Most unit trusts currently meet those criteria, although those that charge performance fees may have to release a separate class that charges a flat fee for these purposes.

The key thing about tax-free savings accounts is that all gains within the account are tax free. Whether that is interest, dividends or capital gain, once your money is in that account you will not pay tax on it in any form.

In a sense, this makes tax-free savings accounts the reverse of retirement products. In pension funds or retirement annuities, your contributions are tax deductible. In other words, whatever you put in gets subtracted from your taxable income. However, you do have to pay tax on what you get out the other end.

Tax-free savings accounts work the other way around. Your contributions are not tax deductible, but once your money is in the fund it will never attract tax again.

So what does that mean in practice? Will tax-free savings accounts save more tax than retirement products?

The answer is yes, and no. If you have time on your side, the tax savings are potentially higher in a tax-free savings account because of the ability to grow your money in the account. Over shorter periods, however, retirement products still come out tops.

In the first year that they come into effect, individuals may invest only R30 000 in tax-free savings products. The total any individual may invest over a lifetime is R500 000. These limits may be adjusted from time to time, but for the sake of this article let us assume that they aren’t.

It will take anyone just shy of 17 years to reach the full R500 000 contribution limit by investing that R30 000 a year. That translates into monthly instalments of R2 500.

If one contributes that amount every month into a tax-free savings account that earns 10% per annum after fees, the below table illustrates how it will grow over 17 years, taking compounding into account:

Growth of R2 500 per month over 17 years at 10%

Total deposits Total gain Balance
Year 1 R30 000 R1 675.70 R31 657.70
Year 5 R150 000 R45 205.95 R195 205.95
Year 10 R300 000 R216 380.05 R516 380.05
Year 15 R450 000 R594 810.66 R1 044 810.66
Year 17 (200 months) R500 000 R788 060.65 R1 288 060.65

To understand how the tax saving in a tax-free savings account works, let’s consider the example of someone with a salary of R300 000 per annum. For that investor, the tax saving of investing this same amount into a retirement annuity (RA) would be of the order of R100 000 over the 17 years. This is realised through reducing her taxable income. (This is a rough estimate, as tax rates and tax-free limits will change, but it provides an idea.)

If she retired at exactly that point and then took that money as an annuity at 4%, it would probably be entirely tax free. This is because we can presume tax brackets, rebates and tax-free thresholds will be adjusted upwards for inflation over this period.

So for someone with only 17 years to retirement, there is unlikely to be any benefit to putting money in a tax-free savings account instead of a RA. However, if the investor was only 25 when she started her tax-free savings account, the picture changes.

After 17 years worth of contributions, she is only 42. That means that the next 23 years she can leave the money in her tax-free savings account to carry on growing.

If she continued to earn 10% per annum on that money until the age of 65, it would have grown to R12.7 million. Treating that exactly as one would treat the same amount in a RA would actually realise a nett tax gain over this period.

Individuals can take one third of their retirement savings as a lump sum, which in this case would be R4.23 million. Making adjustments for changing tax levels, the estimated tax on that would be R200 000 if it came out of a retirement product. So just on that portion there is a nett tax gain of approximately R100 000 if one put the same amount into a tax-free savings account.

If our investor were to take 4% as an annuity on the remaining two thirds, that would be an annual income of R338 000. Tax payable on that in 40 years time is likely to be zero.

So the tax benefit would probably only be on the lump sum portion. However, a rough calculation suggests that this nett tax gain over a RA will only be there for anyone who starts investing in a tax-free savings account before the age of 30 and contributes the full R500 000 in the shortest time allowed.

It is worth noting, though, that tax-free savings accounts have one very important, additional benefit. That is that the entire amount in these accounts can be accessed without restrictions.

There is no limit on what can be withdrawn and there is no requirement to turn any of it into an annuity. So what one gets is a far more flexible lump sum in retirement. Since one can invest in equity only funds, there is also the opportunity to make a more aggressive investment than those that have to meet the requirements of Regulation 28.

So for young investors, these are highly attractive vehicles, as long as you have the discipline not to touch them. Maximising them as early as possible can be highly beneficial in the long run.

The best way to approach this would be to make sure you maximise your R30 000 per year into the tax-free account. Anything above that which you are saving for retirement should go into an RA or pension fund.

As your salary increases and your retirement contributions increase, you then increase the amount you are putting into the RA. And when you finally hit the R500 000 ceiling for the tax-free account, switch the entire amount into an RA.

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