Saving more and investing through a tax-free savings account is a very tax efficient way of ensuring maximum after-tax returns for your hard earned money, according to Francis Marais, research and investment analyst at Glacier by Sanlam.
“Fortunately, in South Africa, we have a few tools to help with achieving maximum tax efficiency. Some are explicit tax savings vehicles, while some are less explicit, but worth keeping in mind,” said Marais.
Regarding the effect of tax on your investment returns, Marais explained that tax can either be deducted periodically (yearly) or at the end of an investment term (once-off). If it is deducted annually, you have a compounding effect, so the value of your investment will be less, versus a once-off tax deduction at the end of your investment term.
Annual deductions from an investment would include tax on interest, dividends and also capital gains tax – should you have sold any investments during the year and realised a capital gain. A once-off tax at the end of an investment period would include capital gains tax on a buy and hold strategy, but also other types of tax such as estate duty.
You should, therefore, try and minimise your annual tax burden as much as possible on interest income, rental income, dividend tax and your capital gains tax due to trading.
“Investing in either a tax-free savings account (TFSA) or a retirement annuity (RA) effectively mitigates your risk of an excessive tax burden and is, therefore, a tax-efficient way of saving. But how would we go about deciding which one to choose?” asked Marais.
The effect of minimal or no taxes becomes much more apparent the longer the investment time horizon, so in the first instance one should make sure that your investment time horizon for the two products is relatively long, in order to gain maximum benefit.
With regards to an RA, this longer time horizon is relatively certain as this is mandated by law. However, this is not so with a TFSA where you can withdraw your money relatively easily.”Therefore the full benefits of a TFSA will require some discipline. If your intention is to save for retirement using any one of these two products, make sure you can make the necessary commitment, and if not, then the RA is your best option,” said Marais.
A major difference between an RA and TFSA is the fact that your contributions to an RA are tax deductible (up to certain limits), but when you eventually start drawing an income from your annuity, the entire amount will be subject to your personal effective income tax rate at that specific point in time.
“It is true that there are a myriad of other considerations when choosing between a TFSA and an RA. For instance, investments in an RA need to be Regulation 28 compliant. This is a constraint that might detract from investment returns, while investments in a TFSA are free from these type of constraints,” said Marais.
“Furthermore your annual contribution to a TFSA is limited to R30 000, so depending on your level of income this might be insufficient. Additionally, for some very affluent individuals the majority of their retirement savings may be in large concentrated positions, outside a formal retirement product, such as company stock options, private businesses and private property.”
This could result in large annual income withdrawals in future, increasing the individuals effective tax rate and thereby undermining the potential tax benefits of an RA. Lastly, from an estate planning perspective it is important to note that your investment in an RA is safe from creditors claims while an investment in a TFSA is not.
“For those with high marginal tax rates it is advantageous to utilise the maximum allowable contributions to your RA first, and then start maximising your TFSA contributions. For those clients with lower marginal tax rates the opposite is true as there is a large probability that their future marginal tax rates will be higher, increasing their future effective tax rates,” said Marais.
“Using the two in combination can deliver superior results and that it should not necessarily be an either/or choice.”
This article first appeared on fin24.com