Question

Are tax free investments worthwhile?

Answer

I do a lot of financial planning for people approaching retirement who have investments that they made many years ago. When they want to withdraw the proceeds of these investments, they are often shocked by the amount of capital gains tax that they have to pay. Had these investments been in a tax free structure no capital gains tax would be payable.

So, if you are looking at investing over a long period, you should certainly consider using a tax free investment structure.  If your investment is a short-term one then the benefits of a tax free structure are not that valuable as the growth and potential tax saving will be low.

There are restrictions when it comes to making tax free investments. You may only invest R36 000 a year into this class of investment. Be careful about investing more than this as you will be penalized and have to pay a tax of 40% on your contribution.

You also have a lifetime limitation on how much you can invest in tax free investments. You are not allowed to invest more than R500 000 over the course of your lifetime.  This is a further reason why you should not use it tax free investment type for short term savings as you will be using up your allowance without enjoying the full benefit of long term tax free growth.

If you invested R3 000 a month into a tax free investment,  you would reach the R500 000 limit after 14 years.  As this is a long term investment, you should be targeting a return of at least inflation plus 4%.  If we assume inflation to be 6% then you should be looking for a return of 10%.

The value of the investment would thus be around R1 060 852 once you hit your investment limit.

If your tax rate was 30%, the CGT you would have paid here if it was not in a tax free structure would be R62 502.

Now the real magic of a tax free investment is seen when you leave the funds in place for long time.

If you left the money in the investment for a further 20 years (remember, you are not allowed to invest anything more), it will have grown to R7 136 882.  Now had this been in a regular investment, you would have paid R791 626 in CGT.  As it is in a tax free structure, no tax will be payable.

To summarize:

This is a fantastic way to supplement your pension and generate a tax-free income through future withdrawals from the investment.

Insider tip

I recommend that parents or grandparents take out a tax free investment in a baby’s name when he or she is born.  When they reach their 30’s they would have access to a tax free lump sum that could really make a difference in their lives.