At the beginning of each year I deposit R36 000 for my tax-free allowance in a tax-free fixed deposit with a certain bank. The bank will give me a rate of 5.9% compounded. Is a tax-free fixed deposit the best way to use my allowance, or should I invest in a unit trust or exchange-traded fund (ETF) portfolio?
A tax-free investment is a great product in your portfolio and I believe the benefits should be optimised here.
The tax-free investment vehicle enables you to grow your capital without paying tax on investment growth. It allows for flexible contributions (up to specified legislative limits) while giving you control over your choice of underlying investment options.
All growth, dividends and interest earned in the tax-free investment plan is tax-free. You may not contribute more than R36 000 per tax year or R500 000 over your entire lifetime. It is up to the investor to manage the limits of investments.
If you have tax-free investments with more than one product provider you will be taxed at 40% for any amounts that exceed the limits set by law. Please note that any withdrawals do not enable you to increase your annual contributions. The investment value forms part of your estate and may be subject to estate duty and executors’ fees.
You cannot nominate beneficiaries. The benefit at death will be paid to your estate.
I see a tax-free investment as a long-term approach – as you only really benefit from the concept if you optimise your R500 000 lifetime limit. This changes the term of the investment to long-term investment – of around 14-plus years, therefore I would not advise investing in a fixed deposit type of structure, but making use of growth assets.
Remember the tax-free investment is just the ‘vehicle’ we are using – the underlying asset classes we decide on is the important part.
The following graph compares a well-diversified portfolio to a cash (money market) portfolio:
The longer the term, the more invaluable growth assets become to ensure you are earning a return well above inflation. I would advise diversifying with asset classes as well as fund managers to optimise this investment and the possible returns.
The added benefit with a tax-free savings account (TFSA) is that you have no regulation or exposure limits, which gives you flexibility and many options – you can even diversify 100% offshore should you wish to.
Looking at ETF exposure within a tax-free investment is definitely something to be considered. ETFs are mostly chosen for the lower fee structure, as this is a passive investing style. I do however see downside risk here. With an ETF you carry the risk of just ‘tracking’ market behaviour and that can potentially hurt you very much in a market crash, as with Covid-19. If you were invested in a more diversified portfolio, the pain would have been less.
Looking at some of our analysts’ work done on this, our Global Creator (multi-manager offshore fund) outperformed the MSCI World Equity index every time over different periods of time.
This brings me back to the point that a well-diversified, actively managed portfolio will be the advised route to go for a longer-term investment.
I believe that optimising your tax-free investment annually – trying to achieve your limit of R500 000 as soon as possible – is good. If you are looking to save more than your annual R36 000 allowance per year, you can start to diversify with a voluntary investment, and look at adding a retirement annuity to your portfolio as well.