Introduced in March 2015, tax-free investments have now been available to investors for three years.
While this is a relatively short history in terms of investment horizon, we are now able to see more clearly how investors are benefitting from the tax savings these vehicles offer.
Among Prudential’s tax-free unit trusts, the most popular investment fund choices have been the Prudential Enhanced SA Property Tracker Fund and the Prudential Balanced Fund.
One of the reasons the property fund is so popular is its potential for relatively higher tax savings and the fact that it boosts potential long-term portfolio returns, as described later in this article.
It is difficult to determine which types of tax-free investments would be the most beneficial to individuals.
The actual tax savings compared to normal (non-tax-free) unit trusts depend on a combination of factors, the primary two being, first, your marginal income tax rate; and, second, the type and quantum of income and capital gains earned in your selected unit trust.
Obviously, the higher your marginal income tax rate, the more you will save in these vehicles. At the same time, fund returns are taxed according to their source of income.
An example of tax savings
Using a hypothetical example to illustrate possible fund returns and tax savings over time, let’s see how much tax savings would accumulate to an investor in the 45% income tax bracket if they had been able to invest tax-free for the past 15 years and selected the Prudential Enhanced SA Property Tracker Fund tax-free unit trust.
They are able to invest the full annual allowance of R33 000 every year for 15 years, which means that they would have contributed a total of R495 000.
This is very near the current maximum R500 000 lifetime limit.
I have used the highest possible tax bracket and allowable contribution expressly to try to provide an indication of what the upper limit of the tax saving for individuals could be.
The graph shows that the R495 000 investment in the tax-free fund would have grown to a total of R2.23m by the end of 2017.
By comparison, the same investment in the non-tax-free version of the Prudential Enhanced SA Property Tracker Fund (the identical fund but not the tax-free vehicle), and at the same fees, would have grown to R1.98m, with R255 000 paid in taxes on interest and dividends (and with no annual exemptions applied).
Then, if the investor decides to sell all or part of the non-tax-free investment, they will have to pay capital gains tax of around R244 000, which will reduce the investment value to R1.74m.
So this makes the tax-free unit trust even more attractive.
The investor would therefore have notched up an extra R500 000 at the end of the 15-year investment horizon solely as a result of the tax-free benefits of this vehicle.
This is a substantial bonus for anyone to add to their retirement income.
A similar example for an investor in the tax-free Prudential Balanced Fund in the 28% marginal income tax bracket would have resulted in an additional R270 000 investment value at the end of 15 years.
Tax-free listed property beats cash over time
It is particularly beneficial to hold listed property companies in the form of real estate investment trusts (REITs) inside a tax-free investment, because there is effectively no corporate or individual tax on the investment returns.
While holding cash inside a tax-free investment may appear very attractive – because it offers relatively high short-term tax savings – cash may in fact be the least appropriate asset class to choose over the long term.
This is because it earns after-inflation annual returns of only 1% to 2% over the long term, substantially less than the 6% to 8% annual real return provided by growth assets like equities and listed property.
The returns on these longer-term investments, re-invested and compounded over many years, will probably be much higher than cash.
A holistic view
While this article focuses mostly on understanding the potential tax savings of tax-free investments, don’t forget the basics when it comes to making the most of investing: develop an appropriate long-term investment strategy; and remember to invest tax-free for your children.
By using tax-free investments in combination with other investment vehicles and allowances as part of a holistic, long-term investment plan, you can substantially optimise your family’s overall investment portfolios.
These tax savings, together with an optimal investment strategy, could have a significant positive impact on your long-term returns.
Pieter Hugo is the managing director of Prudential Unit Trusts.
This article originally appeared in the March 2018 edition of FundFocus. Buy and download the magazine here or subscribe to our newsletter here.