In an article featured in the South African Index Investor’s Fourth Quarter Newsletter, Daniel Wessels, a financial advisor at Martin Eksteen Jordaan Wessels in Cape Town, compares the benefits of investing in a tax-free savings account with a typical discretionary investment (for example a unit trust, ETF or fixed investment or a combination thereof).
The comparison stems from the fact that many of the underlying investments within these tax-free savings accounts will be exactly the same as current unit trusts, ETFs or fixed investments on offer, with the exception that the tax-free savings account will cover these investments in a “tax-free wrapper“. While most product providers still need to launch their tax-free savings accounts, one assumes that some of them will “relaunch” existing products within a tax-free wrapper.
Wessels used the same assumptions for both scenarios, namely a monthly contribution of R2,500 (thus R30,000 per annum), an investment period of 200 months (the time it takes to reach the R500 000 lifetime contribution limit) and an asset allocation of 65% to equities and 35% to interest-bearing assets.
A dividend yield of 3% on the equity portion of the portfolio applies while interest accrues at 7% per annum.
As far as the discretionary investment is concerned, interest is taxed at the individual’s marginal rate and dividend withholding tax of 15% applies. At the end of the investment period capital gains tax is levied.
In comparison all proceeds on the tax-free savings account are 100% tax-free.
The investor in a tax-free savings account would accumulate R1,594,794 over the period if the nominal portfolio return is 12% per annum (12.68% annualised).
The discretionary investor with a marginal tax rate of 30% will only accumulate R1 419 450 over the same period (after tax). “Depending on one’s marginal rate of tax, the tax erosion of investment value can be substantial. With an ordinary investment, and a person paying the maximum marginal rate of tax (40%) up to 15% of the final value that would have accumulated in the tax-free savings account will be forsaken,” Wessels notes.
Fig 1: [Source: Daniel Wessels]
| Marginal Tax Rate | 18% | 25% | 30% | 35% | 38% | 40% |
|---|---|---|---|---|---|---|
| Marginal Tax Rate | 93% | 91% | 89% | 87% | 87% | 86% |
The numbers highlight the significant tax benefit of utilising one or more of these accounts – potentially using the exact same underlying investments as the discretionary portfolio.
“The benefits of the tax-free savings account are real, especially if the investment is kept for the longer term in so far one is maximising the tax benefits from the investment and the compounding effect thereof is given sufficient time to work its magic,” Wessels says.
This is illustrated in Fig 2. It highlights the difference between the performance of a discretionary investor with a 40% marginal tax rate and a tax-free savings account investor where both investors cash out their savings after a specified period.
Fig 1: [Source: Daniel Wessels]
| Period of withdrawal | Margin of outperformance of tax-free savings account relative to the discretionary investment |
|---|---|
| 36 months | 3% |
| 60 months | 4% |
| 84 months | 6% |
| 120 months | 9% |
The tax benefit of the tax-free savings account really becomes significant over a period of 15 or 20 years, Wessels says. Investors who stay invested over the long term and resist the urge to cash out the funds will reap the rewards, he says.
Reproduce by kind permission. [Source: (http://www.moneyweb.co.za/uncategorized/taxfree-savings-account-vs-discretionary-investmen/)]
Weekly Comment Week 11 2015 -RH.pdf
