Tax-free investments
By Freddy Mwabi, Actuarial Specialist, Simeka Consultants and Actuaries
Quarter 1: 2015
Last year National Treasury tabled amendments to the Income Tax Act and introduced draft regulations to allow service providers to offer tax-free investments. These saving vehicles have now been passed into law and will become effective on 1 March 2015. They are intended to encourage a greater level of discretionary saving in South Africa.
Much remains to be done in the development of tax-free investments (TFIs) but with the information at hand, it is possible to assess the tax efficiency of these TFIs relative to retirement funds and collective investment schemes (CIS).
How tax efficient are TFIs?
Consider a 40 year old individual who earns a salary of R10 000 per month and in respect of whom the employer makes a monthly contribution of R1 000 to a provident fund over a term of 20 years. Compare this to a similar investment in a TFI or CIS. Assuming the contributions are placed in a balanced fund earning a return of 5% above inflation, our projections show that the provident fund investment will be 10% better than the TFI which in turn will be 16% better than the CIS. In this exercise we assumed exactly the same cost structure. The difference will be even bigger once we can factor in the actual costs of each investment type.
| Description: A: R10 000 pm salary: R1 000 pm investment | Provident Fund | Tax-free investment | Collective investment |
|---|---|---|---|
|
Total contributions (net after tax) Plus: Investment returns Less: Tax on dividend, interest and capital gains Retirement lump sum tax |
R 567 000R 901 000-(R 281 000) | R 394 000R 681 000- | R 394 000R 659 000(R 125 000) |
| Lump sum net of tax at retirement | R 1 187 000 | R 1 075 000 | R 928 000 |
If the individual earns R100 000 pm (taxed at the highest marginal rate) the provident fund investment will be 35% better than the TFI which in turn will be 14% better than the CIS.
| Description: B: R100 000 pm salary: R1 000 pm investment | Provident Fund | Tax-free investment | Collective investment |
|---|---|---|---|
|
Total contributions (net after tax) Plus: Investment returns Less: Tax on dividend, interest and capital gains Retirement lump sum tax |
R 567 000R 901 000-(281 000) | R 340 000R 541 000– | R 340 000R 526 000(R 95 000)- |
| Lump sum net of tax at retirement | R 1 187 000 | R 881 000 | R 771 000 |
It is clear that individuals who are in a higher tax bracket will benefit more. The above analysis also shows that the provident fund investment will produce the best net after tax retirement outcome by far. It really is a virtual tax haven.
The provident fund and TFI have the same advantage over the CIS in that they are exempt from dividend, interest and capital gains tax. The tax efficiency of the provident fund is amplified by the fact that contributions (made by the employer in respect of the member) are tax deductible. That means the full amount is available for investment while the contributions to TFI and CIS are made with after tax income. At retirement however the provident fund benefit is subject to retirement fund tax. The comparison shows the favourable taxation enjoyed by retirement fund investments despite this tax.
Much the same result would have been obtained if we compared a pension fund investment. In such a comparison we would have to compare the after tax annuity income of each investment, not the after tax lump sum at retirement. This is a more complex calculation and less easy to explain.
Conclusion
The introduction of tax free investments remind us just how tax efficient retirement funds are. Add to that the economy of scale offered by a group arrangement and one will not find a more effective retirement fund investment in South Africa. TFIs however will be much more tax efficient than a CIS investment. If individuals wish to build up a nest egg in addition to their retirement funds – one that they can have access to in the event of a life crisis, a TFI would be a very good choice.
It should be possible for employers to provide institutionally priced TFIs to their employees as a voluntary benefit arrangement in addition to their current retirement fund. These investments have the potential to help develop a savings culture in South Africa. Used correctly they may also add to the stability of the workplace and prevent many members from resigning when they have a life crises in order to gain access to their benefits.
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