I invested R33 000 in a Nedbank tax-free fixed deposit and discovered that the interest cannot be reinvested into the same investment thereby benefitting from compound interest. I cannot make sense of this. Where can I open a tax-free investment where I benefit from compound interest?
Firstly, I would like to congratulate you on having a tax-free investment. This product can play an exceptional role in any investment portfolio and I believe the concept behind it is fantastic. Plus the annual limit has recently been increased to R36 000 per tax year.
Compound interest is referred to as the “eighth wonder of the world’. The basics of compound interest can be explained as follows.
- Suppose you have R1 000 earning 8% per year – that is R80 per year.
- After the first year, you now have R1 080; if you receive another 8% interest the following year, you will now earn R86 interest, taking the total to R1 166.
- In the beginning, the effect of compound interest is small, but over time it gains momentum and the increases become significant.
Benefiting from this as much as possible will, however, depend on the underlying building blocks of this investment – and I would advise investing in growth assets (equity exposure) to ensure that you benefit in the longer term and earn a return that outperforms inflation.
The tax-free investment vehicle enables you to grow your capital without paying tax on investment growth.
When looking at the possible tax implications of any voluntary (accessible) portfolio over the longer term – whether in the form of share options at work, a personal share portfolio or a voluntary investment – with time, income tax and capital gains tax (CGT) can become a problem. The benefit of a tax-free investment is that none of these risks will apply. All proceeds will be able to be withdrawn one day – completely tax-free.
We are even starting to advise using this product as part of one’s retirement planning structure – ideally, when you get to retirement stage, you will be able to earn an income from this investment for a year or two without any tax being payable.
Exactly for the reason mentioned above, I would firstly not advise being invested in a fixed-income type of structure, as we want to benefit from growth assets (equity exposure) in this investment in the long run – and we never need to be concerned about possible CGT in the long term.
Tax-free investments are not subject to regulatory requirements when it comes to asset allocation, unlike the Regulation 28 provisos that affect retirement annuities. This means you can benefit from more equity exposure and more offshore exposure, which will be very beneficial in the longer term.
I would advise investing this product with a wealth manager on an investment platform and following a unit trust approach, well-diversified – but definitely focusing more on equity exposure. The benefit with this investment comes with time, so aim to invest your full R36 000 allowed per tax year, and reach the R500 000 limit as quickly as possible.
If you can leave these funds for another few years, that’s ideal! Reaching your R500 000 lifetime limit will take around 14 years. This automatically makes it a longer-term investment, and being invested in equity exposure (growth assets) is definitely advised.
The graph below compares the following:
- A money market fund
- A multi-asset income fund
- A moderate fund (balanced fund)
- Local equity fund, and
- A global equity fund.
It has been a few difficult years in the shorter term for local equity exposure. However, looking at offshore equity exposure, growth assets outperform cash significantly, more so in the longer term. If you are planning to maximise your tax-free savings account by contributing your annual R36 000 to the maximum limit of R500 000, adding equity exposure to your allocation is definitely advised.
You will also benefit from rand cost averaging.
Rand cost averaging is an investment approach that involves investing a fixed amount at regular intervals over a prolonged period. The concept of rand cost averaging is rather simple, and is very effective in times of heightened volatility and uncertainty. When markets are down, you are purchasing more units or shares, and on the contrary, when markets rise you purchase fewer units.
A common mistake that investors often make is trying to time the market. In theory, this is a simple concept, but in reality, very difficult to accurately execute. Making use of rand cost averaging by investing monthly is a lot more prudent and beneficial than taking the risk of timing the market and getting it wrong. Consistent contributions force you to do the right thing by buying more shares at a lower price, resulting in better long-term performance and enjoying the principle of compound interest even more.