Most parents want to leave their children a legacy, but what if you could leave your children a secure retirement? A retirement that they never have to save a cent towards and that is completely tax free?
According to Nic Andrew, executive head of investments at Nedgroup Investments, this is exactly what would happen if you invested R2 750 a month into a tax-free investment from the day your child was born until they turned 18 – and then left the capital to grow for a very long time.
Assuming you invested R2 750 a month, you would invest R33 000 per year which is currently the maximum annual amount allowed in a tax-free savings account (TFSA).
The current life-time cap is R500 000 which you would reach by your child’s 15th year, but in Andrew’s example, he assumed government increases this cap to R600 000. You would reach this limit by the time your child turned 18.
As this is a long-term investment, you would invest in a fund with growth assets that include South African and global equities ‒ so ideally a unit trust fund or an exchange-traded fund.
The long-term average annual return from equities is around 7% above inflation, so by the time the child turned 18, you would have invested R600 000, but the fund would be worth R1.1 million in today’s value, having adjusted for inflation.
Think about that for a moment: your child would have R1 million, in today’s value, on their 18th birthday.
The importance of staying invested
But here is the important part: instead of cashing the money in to buy a BMW or a gap year, the child keeps it invested until age 60.
According to Andrew, by the time your child is ready to retire, that investment would be worth over R20 million in today’s value.
Your child could draw an income of R130 000 a month and it would still last until they were 100 years old. And because it was invested in a tax-free investment account, the proceeds would never be taxed.
Even if the child had taken half of the proceeds at the age of 18 to pay for education or start a business, by leaving the other half to grow, they would still have R10 million on retirement – in today’s value.
Admittedly, not everyone has R2 750 a month to put away, but what if you just started with R500 a month? By the time your child turned 18 they would have a nest egg of R215 000. If the child left that for retirement and let the power of compounding take over, it would be worth R4 million in today’s value by the time they turned 60. How many parents have that kind of retirement benefit? All that from just R500 a month.
Where to invest
Most people are familiar with the bank offerings for tax-free savings accounts, but these are not necessarily the right investment for the long term. A bank TFSA invests in a money market account which can only ever receive interest based on the current interest rate. This is insufficient to provide for a real, after-inflation, return.
The example above assumed a real return of 7%. This means the fund performed 7 precentage points above inflation over the long term. In comparison, cash at best would perform at inflation or maybe 1 percentage point above inflation. For example, currently one of the bank’s rates on the TFSA is only 4%, which is actually below the current inflation rate of around 5%.
According to Nic Andrew, the JSE All Share Index (all of the shares in the South African stock market) has delivered 7 percentage points above inflation over the long term. For example, if inflation is 5% then the JSE return would be 12%.
In the shorter term, the JSE could return less, as we have seen over the last four years, but over a 40-year period it should return more than cash, as it is a growth asset and needs to deliver a risk premium. People would not take the risk of investing in the market if they were only to receive cash-like returns.
So, if you are looking to invest for your child’s future, then you should consider a TFSA offered as a unit trust or exchange-traded fund where the underlying investments are in shares. You can invest in a unit trust that gives you a wide range of assets including offshore and property. The key is that you invest in growth assets, not cash.
This article first appeared in City Press.
One major assumption is that Government dont ever change their minds and tax these savings?
Excellent question. The tax saving on these are relatively small compared to other areas government could consider taxing. What we know from past changes to tax legislation is that it is never retrospective. In other words they may say you can no longer save new money into a TFSA but they would never remove the tax arrangement on existing funds. That makes starting a TFSA even more compelling – use it before you lose it 🙂
Excellent advice. Question – what are the regulations around transferring a bank TFSA balance to an alternative savings vehicle? does this impact your lifetime contribution as it will show as a withdrawal from the bank?
You can transfer from one TFSA product to another without affecting your lifetime limit – but you need to do it as a transfer, so don’t sell and re-invest. Ask the new provider to give you the correct forms
Best recommendations or places to have a TFSA?
There are so many to chose from – but not a bank account if you are looking for a long-term investment. Look at Satrix, Coreshares or the unit trust companies – just watch the costs