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A value investor’s guide to tax-efficient investments

Tax-efficient investments compared according to life stage.

Most investors recognise the simple maths. Paying less tax on gains from their investments will increase their net worth. However, as the South African tax regime has evolved over time, so has the array of options to manage tax on investments. Investors are often overwhelmed and confused, and as a result, may either choose options purely to lawfully avoid paying any tax, which may not maximise their returns, or even worse – they do nothing. These are both missed opportunities – and what should be legitimate “money-in-the-bag” is left on the table.

This article outlines a few tax-efficient solutions available to individual investors, while also highlighting the circumstances in which they might make the most sense. We admit – this is a value investor’s view of the world – and does not take into account any specific investor’s individual circumstances. Comprehensive advice is best obtained from a qualified financial advisor, based on the circumstances of each individual.

Tax in many guises

Tax on investments is paid in various forms, including tax on interest or rentals received, tax on income drawn from an investment, tax on dividends received, and capital gains tax when an investment is sold. Minimising any of the above improves the net return. Even deferring any of the above to a point later in the future is beneficial to investors as it allows investments to compound off a larger base up until that point. Tax savings can also be gained upfront, as is the case with retirement annuities, where individuals are able to make contributions from pre-tax income.

The impact and significance of any of the above tax savings varies widely, depending on individual circumstances. A broad guide based on age and stage serves as a useful starting point in considering what might make the most sense for an investor. The products considered in this article are tax-free investments, retirement annuities and endowments. Please see the appendix for a brief description of each.

AGE AND STAGE 1: A minor under the age of 18

The main benefit of investing in a tax-free investment on behalf of a minor is time. Capital invested earlier can compound for longer, in a portfolio with the widest possible opportunity set. Add to this a zero-tax regime and the outcome is material.

If the current maximum annual contribution of R33 000 is utilised every year, it would take an investor 16 years to get to the lifetime maximum of R500 000.

To demonstrate the significance of a combination of an early start and zero tax on your returns – consider two investments, spread as above, but starting five years apart. (See Chart 1). A tax-free investment with the above profile, which starts immediately, and generates 6% real returns, will lead to a difference of more than R300 000 in today’s money after 20 years when compared to an investment that starts just five years later.

 

 

Parents and grandparents need not be overly concerned with “using up” the full R500 000 lifetime limit for a tax-free investment on behalf of their children or grandchildren. Since there is a cap on the annual contributions, contributions need to be spread over a long period anyway. Further, by the time a young adult starts to earn their own income, there are better options available, such as a retirement annuity.

A retirement annuity, which does not make sense for minors who don’t earn an income, may well be the best option for individuals during the income-earning parts of their life.

A further benefit however of a tax-free investment is that the investor can determine the profile of ultimate withdrawals. If the redemption is structured as a series of monthly payments, this in essence turns into a tax-free income over time.

Consider this: A tax-free investment from the first year of a child’s life, using the full allowance annually, up to R500 000 in total, assuming a real rate of 6% per annum, would be worth R11.2 million in today’s terms when the individual is 60 years of age. In contrast, the same investments annually, starting from the age of 30 instead, would be worth only R2 million at age 60.

 

 

 

A 5% income drawn annually from the capital, which would be entirely tax-free in the case of a tax-free investment (but taxable if from a retirement annuity), at age 60 for the first investor would amount to R563 793 per annum – more than five times more than the second investor who started at age 30, earning an income of R104 052 per annum (again – in today’s money).

Using a tax-free investment for cash or yield-oriented investments doesn’t make much sense for two reasons: Firstly, no tax is incurred until interest earned by an individual exceeds the current exclusion limit of R23 800 per annum. Put another way – an investor earning a 7% yield on a money market fund could invest up to R340 000 outside of a tax-free structure without incurring any tax on the interest earned. So unless the investor wishes to invest substantially more than this, there is no need to use their tax-free investment allowance for this purpose.

AGE AND STAGE 2: An employee earning income

The benefit of the tax saving that comes with contributing to a retirement annuity from pre-tax income makes this the most compelling tax-efficient solution for any income earner paying more than roughly 20% marginal tax. (For lower-income earners paying less than 20% tax, factoring in the tax that is potentially paid on the lump sum and income after retirement, the tax-free investment could actually be more compelling.)

Secondly, although it is true that the capital in a tax-free investment is not locked up as it is in the case of a retirement annuity (which could prove useful in an emergency) investing the tax-free allowance in a lower-yielding investment option significantly impacts the potential benefit over time. Ideally, the capital should be left to compound, tax-free, for as long as possible in the highest-yielding asset class. To demonstrate the potential impact of a lower return investment, consider three tax-free investments, again utilising the maximum allowance annually, but invested in cash, bonds and equity. Assuming long-term real returns of 1%, 2% and 6% per annum respectively for these asset classes, in today’s terms, the same R500 000 contribution amounts to R546 925 if invested in cash, R598 838 if invested in bonds, and R868 345 invested in equities. Left to compound for a further ten years, the gap in returns between the three asset classes widens even further with equities delivering more than double the return earned from cash.

 

A retirement annuity however normally carries Regulation 28 restrictions in terms of the asset that could be held in this form. Equity is restricted to a maximum of 75% and offshore assets to 25%. Retirement annuities also normally have restrictions in terms of access to the underlying assets before retirement age – which is set at minimum age 55.

A tax-free investment makes sense for income earners who have already reached the maximum contributions allowed to their retirement annuity, or for those who would like more flexibility in terms of investment options, and access to capital in an emergency.

AGE AND STAGE 3: Retirement

After retirement, an investor’s marginal tax rate is determined by income drawn from the retirement products and other taxable income. If this rate is greater than 30%, an investor may well consider an endowment policy issued by a life insurance company to house their investments. The investor would not benefit from any exemptions on interest income and capital gains for assets in this form, but this may still be worthwhile if tax paid is at a lower rate than would otherwise be the case. Endowment policies have a five-year minimum life however, which imposes liquidity constraints on a portfolio.

The maximum size of a tax-free investment does not allow it to compete head-on with endowments and retirement annuities as a complete solution post-retirement for most investors – unless the full amount is invested early enough for the capital to grow to a worthwhile amount. However, there is very little downside for investors to take advantage of the opportunity to invest this R500 000 without any tax implications in future, into a wide array of products while still having it available if liquidity were ever a problem.

Conclusion

The most powerful force in investing is compounding. If you are able to compound off a larger base through paying less tax or paying tax later, or you are able to compound for a longer period of time by investing as early as possible, this has a formidable impact on the returns generated over time.

Evidence shows that value investing trumps other investment styles over the long term by allowing the greatest inefficiencies in the market to be exploited. The longer the time horizon, the better this is able to work in an investor’s favour as markets are erratic and mispricing does not typically correct itself overnight.

This combination of the tax savings, and the value investment style delivering the best returns available to investors when afforded the time horizon to do so, makes a tax-free investment a worthwhile gift to your future self or indeed, your loved ones.

Summary of tax-efficient priorities given age and stage

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Some investing advise is for the “cannon’s” and some for the “cannon-fodder”. Not sure this one is for the cannon’s.

I know this article is about the tax considerations for long term investing. But is the tax atributes of a retirement annuity really that valuable considering:
– Regulation 28 limitations
– The swapping of dividend withholding tax and capital gains tax for future income tax

These examples always assume 6% real returns. Is this really possible when 75% of the investment MUST be in SA.

Good taxable returns always outperform pedestrian tax efficient returns

An RA does not swap DT and CGT for Income tax.

It defers the payment of income tax, and eliminates the other taxes you would be liable for in the interim.

If I have R1 to invest before tax and my marginal tax rate is 45%: I can invest 55c in the Allan Gray balanced fund unit trust, or I can invest R1 in the AGB Fund unit trust in an RA wrapper.
If the fund grows 10 fold by the time I retire and I withraw this contribution, I will have R5.50 to spend from the unit trust investment, or I will receive R10 from the RA on which I will pay tax of R4.5 (assuming my marginal rate is still 45% at this time), leaving me with the same R5.50 to spend.

I will however have paid other taxes on the unit trust investment over the period of the investment which I avoided in the RA.
I also get the benefit of the lower tax rates on the RA lumpsum payment. It is also likely that my marginal rate will be lower in retirement.

You do indeed swap DWT and CGT for future Income Tax, under the guise of tax deductions in the present.

What you say is true, but whilst you will pay 18% and 20% tax on the returns now (if nit in wrapper), you defer that to pay marginal rate on it in the future.

Model it. Depending on your growth assumptions and retirement marginal rate assumption you will be surprised.

And also practically, hardly anyone saves the R1 instead of the 55c. That is only the case if you take your tax refund, or increased monthly take home pay and invest that as well. If you go to Spur or holiday with that, you did not really invest pre rax money

I have modeled it, you are wrong.

My Model
Assumptions:
R1000 investment by person with no RA type deductions by employer or self employed
Marginal Tax Rate before retirement 41%, after 39%
Dividend WT 20%, CGT when retired 15,6%
RA deduction not capped, interest received all taxed
Returns, reinvestments and tax rebates all invested at end of year
Balance fund return 4% real growth + 8% interest yield + 3% gross dividend yield (75/25 split equity/bonds)
Euquity fund return 5% real growth + 0% interest yield + 3% gross dividend yield (100% equity)
Claculate Income Tax and CGT due on retirement on full balance on that date
Investment horizon 40 years

Results:
Balance Fund in RA with Reinvestment R250,000 after income tax
Balanced Fund in RA no Reinvestment R183,000 after income tax
Balanced Fund in TFSA R300,000 no income tax applicable
Balanced Fund no wrapper R197,000 after CGT
Equity Fund no wrapper R217,000 after CGT

This problem is actually so simple you can rely on logic to explain why the RA has to be superior to the other options from a tax perspective – as I did in my 1st post. (note I am not arguing here about the other aspects like Reg. 28 and possible future changes in the tax regime).

But lets take your comparison between RA and TFSA above – It is impossible for the TFSA to come out ahead of the RA if pre-retirement marginal rate is higher than post retirement, so I am very interested to see how your model manages that.

Both wrappers allow us to ignore DT and CGT so:
If I assume a pre tax investment of R1000 pa for 40 years in the same balanced fund and I use a nominal return of 10% (4% real + 6% inflation). Then:

RA: in excel notation FV(.1,40,1000,0) = R442593
If I then withdraw it at a marginal rate of 39% I get R269981 after tax.

TFSA: I have to pay 41% tax on my R1000 1st so I am left with R590 to invest = FV(.1,40,590,0+ = R261130 after tax.

I would love to know how you get to R250000 for the RA and R300000 for the TFSA.

I will like to share the file with you for your opinion. Because as I see it:

1 – Asset allocation is most important
2 – RA only nakes sense if tou re-invest the rebate
3 – Be carefull for swapping CGT and DWT for future income tax
4 – TFSA trumps RA

You can share it on Google drive and post the link here – I would like to have a look at it.

– Asset allocation – I don’t want to get into that debate here, my argument is that given the same portfolio the RA at a minimum allows you to eliminate DT and CGT vs a unit trust portfolio and there is no swapping of those taxes for income tax.
I will say that in economics we are not concerned with maximizing returns, but rather optimizing returns, so we use things like sharpe ratios rather than just the highest expected return when evaluating allocations. 100% equities is not a good idea for most retirement plans.

– reinvesting the rebate is one of my a basic assumtions. If you don’t, you still have to account for the uitility of the rebate in your model. After all if I choose to by more steak with it, I am still better off than the guy who has to pay more tax and eat baked beans.

– no 3 is not true

– 4 is not true. Both wrappers treat DT and CGT the same, but with the RA you get the added advantage of deferring tax from a high incom period in the life cycle to a low income period, when marginal rates are expected to be lower + a lump sum can be taken at preferential tax rates.

Very good analysis, it is challenging to quantify these benefits for clients and the visuals are great.

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