I am a 56-year-old man with a six-year-old daughter. I have R36 000 that I am thinking of investing in an African Bank fixed deposit account (10.5% interest) for my child for five years. Is this the right thing to do? Or should I open a unit trust account for her?
When comparing interest-bearing investment options it is important to understand how the quoted interest is calculated. Does the rate refer to simple interest, which is a rate calculated on the principal investment amount, or does it refer to compound interest, which is the effective interest rate earned when you do not withdraw the interest earned every month?
Fixed deposit investments often quote the simple interest rate which can be confusing when comparing the return to that of other investments indicating compound growth, like unit trust funds.
A simple interest rate of 10.5% on a principal amount of R36 000, would earn you R3 780 per year for five years. If you were to reinvest the interest, you would receive five times this amount plus the principal amount at the end of the five-year term. This equates to a payment after five years of R54 900. This converts to a compound annual interest rate of 8.81%, which represents the effective interest earned if you reinvest rather than withdraw the interest earned.
Another important factor to consider is whether you require flexibility. Do you require access to the funds within the five-year period? Would you like to make additional contributions to the investment? Under exceptional circumstances a withdrawal from a fixed deposit will be permitted, however penalties will apply. Furthermore, fixed deposits don’t permit additional contributions to be made within the fixed term.
From an income tax point of view, it is also important to note that once you have exceeded your annual interest exemption, all interest earned will be taxed at your marginal tax rate. Persons younger than 65 years qualify for an annual tax exemption of R23 800, which means that all interest earned up to this amount in a particular tax year is exempt from income tax. If, for example, your marginal tax rate is 30% and you no longer have your tax exemption available to you, you will have earned an after-tax compound interest of 6.49%. This figure is significantly less than the 10.5% considered at face value.
When considering the tax implication, you might also consider making use of a tax-free savings account if you don’t have one already.
This product allows a maximum annual contribution of R36 000, which happens to be the amount that you have available. In addition to offering tax-free returns, this product usually offers access to the funds should your needs and objectives change. You can also add to this investment within the maximum allowed annual contribution limits. With a minimum considered investment horizon of five years, one can consider structuring this investment in a way that may include growth assets, like equities, which may be volatile in the short term, but have a high likelihood of significantly outperforming inflation over time and creating wealth.
In the likelihood that you already have a tax-free savings account or plan to specifically make use of this product to address an alternative investment goal, you might consider making use of a unit trust investment which also offers flexibility as well as the option to structure the underlying funds with a growth focus in mind, by making use of growth assets. From a tax point of few, equities are not interest-bearing investments where taxes are paid on the interest earned. Realised capital gains are taxed at a maximum effective rate of 18% after the investment term. Currently, an individual also qualifies for a R40 000 exemption per tax year on capital gains realised in the tax year.
Dividends withholding tax of 20% also applies. Although this tax is payable by the beneficial owner, the beneficial owner’s responsibility in this regard is usually fulfilled by a withholding agent (e.g. the unit trust management company) at payment stage (hence the name).
I have elaborated briefly on a few factors for you to consider and have made several assumptions in doing so, however it is always recommended you speak to a financial advisor, who will guide you through the options, given your unique needs, circumstances and risk tolerance.