By Jaco Prinsloo, Financial Planner at Alexander Forbes Financial Planning Consultants.
The close of the tax year is drawing near, meaning those wanting to make use of the tax-free savings account allowance have their last opportunity on February 28 to put money away in the current tax year.
This is a good time to evaluate if a Tax-Free Savings Account (TFSA) is a suitable investment vehicle for you. Assuming an investor has already maximised their contributions to their retirement funds and now has some extra cash to invest, what is the best option between a normal unit trust and a TFSA unit trust?
|Unit trust||TSFA unit trust|
|■ No annual or lifetime limit on contributions
■ Flexible; you can add and withdraw funds as needed
■ A wide range of investment portfolios and assetclasses to choose from
|■ No tax payable on interest, dividends or capital gains.
■ Low cost and no performance fees
|■ All income or revenue generated from the assets are subject to income, dividend and capital gains tax
■Higher fees leading to lower returns in the long run
|■Annual contribution limit of R33 000
and lifetime limit of R500 000
■If you withdraw a portion of your TFSA
you lose the lifetime allowance equal to the portion you withdraw
Using interest as an example, investors under the age of 65 are entitled to a tax-free interest exemption of R23 800 in a tax year. Investors older than 65 can earn up to R34 500 in interest tax free. Assuming you have already used your yearly interest exemption, interest earned above the tax-free interest exemption of R23 800 will be taxed at your marginal tax rate. A marginal tax rate of 45% can turn a pre-tax return of 8% into an after tax return of 4.40%.
Investing a fixed R33 000 for 10 years at a nominal growth rate of 8% in a TFSA will result in an investment value which is approximately 2% higher at the end of term, compared to a similar investment made into a unit trust fund.
The tax saving on a TFSA might be lower than expected, but one has to remember the tax saving is only on the investment growth and not on the contribution (like with a retirement annuity). A large portion of the unit trusts growth is also tax free due to the interest exemption.
The longer the investment term and the higher the interest returns, the higher the tax savings will be, thus using a TFSA as a long term investment will offer better results. Pre-retirement, the TFSA can be used in conjunction with a retirement annuity to maximise the tax benefits. After retirement, the TFSA can be used with a living annuity to supplement the income. Income drawn from a TFSA will be tax free and lower the effective tax rate of the investor.
A unit trust can also be used to supplement the income but tax on interest and capital gains tax may be payable on the income.
The fact that you don’t have to pay tax on the growth of your investment in a TFSA makes this a far more effective way to reach your goals.
The tax-free return and lower fees on Alexander Forbes TFSA compounds the benefits of the investment. No performance fees or variable costs are allowed on a TFSA, which makes the investment cheaper and simple to understand.
The annual fee saving on Alexander Forbes TFSA can easily range from 0.10% to 1.20% compared to a unit trust fund. The tax-free return and lower fees on a TFSA will result in a higher return compared to a unit trust fund invested in the same investment portfolio.
Although you can make withdrawals from the TFSA during the investment term, such as in the case of an emergency, to maximise the benefits from a TFSA, the TFSA should be used as a vehicle to achieve long-term goals, such as a supplementary income at retirement, or as a future education fund.
Investing your money in a prudent manner involves understanding the tax implications of your investment choices. Once you understand how these investments work tax wise, you can develop a strategy to save and plan for the future.