By now, we should all be aware of the tax incentives offered by government to encourage savings via tax-free savings accounts, but Jaco van Tonder, head of Advisor Services in South Africa at Ninety One, urges us not to forget the other tax incentives that we should all be taking advantage of.

The media hype about tax-free savings accounts (TFSAs) may take investors’ eyes off the other tax incentives available to them. There are other ways investors can benefit, particularly if they start the new tax year with a clean slate that makes the most of available tax incentives for long-term savings products.

Tax incentives for retirement savings

By far the most important of all of the tax incentives is the tax deduction offered for your contribution to a registered retirement fund (either through their employer or via a retirement annuity).

There’s a lot of debate on whether the tax benefits of retirement funds are enough to compensate for the investment restrictions imposed by Regulation 28 – specifically the 30% offshore exposure limit (although this has now been increased to 45%) and the three-year delay in accessing retirement assets upon emigration.

We did some modelling work to quantify the value of retirement fund tax benefits over the lifetime of a pensioner. In addition to the well-known estate duty benefits of retirement funds, we concluded that the tax savings typically accumulate to an additional investment return of 2%-2.5% p.a. over the lifetime of a retirement fund member.

This is a material performance advantage and, unless an investor is planning to emigrate soon, we believe there remains significant long-term value in contributing to a retirement fund every year.

Key takeaway: For most investors, contributing to their long-term retirement plan remains the priority.

Maximise your annual interest exemption

Another of the tax incentives offered to savers is the annual tax-free interest income exemption, which is R23 800 for individuals under 65 and R34 500 for people aged 65 and older.

At money market rates of between 4% and 5% p.a., you can safely keep approximately R400 000 in fixed-income investments before paying any tax on the interest earned. This can be used to set up an emergency cash fund.

Key takeaway: Make sure you have an appropriate emergency cash reserve in place as part of your overall investment portfolio and use available annual interest exemptions.

Don’t forget about your annual CGT exclusion

Due to its relatively small size, many investors forget that the first R40 000 realised capital gain in a tax year for an individual investor is excluded from the calculation of the investor’s capital gains tax (CGT) liability.

Your financial adviser should be rebalancing your investment portfolio on an annual basis to keep it aligned with the your risk profile. Ensuring that these annual rebalances happen in the correct tax year can save you unnecessary CGT.

Even though the maximum tax saving is only around R7 200 per year currently (R40 000 x 40% x 45%), the saving will compound to a reasonable amount of money over time. So keep an eye on the date (relative to tax year-end) that you rebalance your long-term investment portfolio.

Key takeaway: Your annual capital gain exclusion, whilst small, can compound to a meaningful amount over time.

Set up a TFSA for the long term

When TFSAs were first introduced, many investors and advisers underestimated the extent to which TFSA tax benefits need time to compound. This is because a TFSA contribution is not tax deductible upfront like a retirement fund contribution, which makes it difficult to calculate the rand value of an investor’s TFSA tax benefit in advance.

In addition, the lifetime TFSA contribution limit further delays the real tax benefit to the period when you have used your full lifetime contribution allowance.

These points are best illustrated by an example. In the figure below, we project a TFSA’s fund values over a 20-year period, based on the following assumptions:

• An investor contributes the maximum annual amount of R36 000, and this limit is never increased by National Treasury.
• The R500 000 lifetime limit is never increased, and contributions cease when this limit is reached.
• The investment return is 10% p.a. and inflation is 6% p.a.
• The investment return is split roughly 50/50 between interest and capital gain, resulting in an effective combined tax rate of 30% on total investment returns.

From the diagram there are three key points to note:

The investment return (the pink bars) takes a long time to accumulate and only really becomes meaningful after about ten years. In the first five years the impact of the tax benefit is incredibly small. Yet after 20 years the tax saving represents more than 20% of the total fund value.

It is therefore clear that, from a tax benefit perspective, it does not make sense to utilise a TFSA for an investment horizon shorter than ten years. This picture changes dramatically after ten years due to the well-known compounding effect of long-term investment returns.

Because your TFSA needs to have a long-term investment horizon, you need to select investment options with the strongest long-term return potential. Research shows that conservative portfolio choices merely reduce the long-term investment return without really adding anything.

Fixed income investments in a TFSA can appear attractive as they attempt to maximise the value of the tax saving – the logic being that interest is taxed at a higher effective rate than capital gains, therefore with a fixed-income portfolio you maximise the value of the tax benefit.

This logic is flawed as it is not only the value of the tax saving that matters, but the sum of the tax saving and the investment return achieved, and we know that fixed-income investment returns disappoint over the long term compared to equity returns.

We would suggest a good starting point for most TFSA investors to be South African unit trust funds from the ASISA Domestic Multi-Asset: High Equity or similar category. These funds have historically produced very attractive long-term risk/return trade-offs, and work even better when tax does not affect the investment decision.

One can comfortably move even higher up the risk curve, especially for longer investment horizons. For example, by far the most commonly selected investment option for the Ninety One IP TFSA has been the Ninety One Global Franchise Feeder Fund.

Key takeaway: TFSAs need to run for a minimum of ten years, otherwise the tax benefits are wasted, and they should therefore have investment portfolios structured to maximise long-term investment returns. Cash and fixed income are poor long-term investments.

Don’t withdraw from a TFSA unless you absolutely must

Current TFSA product rules do not allow you to recover any part of the lifetime TFSA contribution limit should you dip into your TFSA to fund an emergency expense. Every time you use part of your contribution allowance, that allowance is gone forever.

Any redemptions from a TFSA therefore waste part of your lifetime contribution allowance –something to be avoided. For that reason, using your TFSA for an emergency short-term cash reserve is not a good idea.

Key takeaway: TFSA lifetime credits are very valuable, so don’t waste your credits by dipping into your TFSA.

Make the most of the available tax incentives

The introduction of TFSAs in 2015 has been a very successful initiative from government to encourage savings in South Africa. The initiative has really focused attention on the different tax incentivised savings vehicles available to SA investors.

It is, however, important for advisors to review all the available tax incentives that are available, and to not lose sight of investors’ other important savings goals – particularly saving for retirement.

This post was based on a press release issued on behalf of Ninety One.