Picture: ISTOCK
Picture: ISTOCK

Introduced in March 2015, tax-free investments have now been available to investors for nearly three years. While this is a relatively short history, we are able to see more clearly how investors are using these investment vehicles to benefit from the tax savings they offer.

Many investors have contributed on a monthly basis throughout the year and others rush to make their full annual contribution before the end of each tax year, but some are investing their maximum allowance at the beginning of each tax year, thereby gaining an additional year of tax-free investment and a corresponding boost to their investments.

Among Prudential’s tax-free unit trusts, the most popular choices have been the Prudential Enhanced SA Property Tracker Fund and the Prudential Balanced Fund.

One of the reasons the property fund is popular is its potential for relatively higher tax savings while also enhancing potential long-term portfolio returns, as described below.

Yet no matter which tax-free investment vehicle you choose, it is important to remember to make sure it fits within a holistic long-term financial plan.

Focus on how to maximise your long-term, after-tax return, not on simply what gives you the biggest short-term tax saving from your investment.

That said, it is concerning that a high percentage of tax-free products are being opened in short-term cash or near-cash investment vehicles.

While it may seem like holding cash inside a tax-free investment is very attractive, because it does offer relatively high short-term tax savings, it may in fact be the least appropriate asset class to choose over the long term.

This is because it earns long-term after-inflation annual returns of only 1% to 2%, substantially less than the 6% to 8% annual real return provided by growth assets like equities and listed property.

The cumulative returns on these longer-term investments, reinvested and compounded over several years, will most likely be much more powerful than cash.

It’s particularly beneficial to hold listed property companies in the form of real estate investment trusts (Reits) inside a tax-free investment.

This is because there is effectively no corporate or individual tax on the investment returns.

Taking a hypothetical example, let’s see how much tax savings would accumulate to an investor in the 45% income tax bracket if he or she had been able to invest tax-free over the past 15 years and selected the Prudential Enhanced SA Property Tracker Fund.

The investor invests the full current annual allowance of R33,000 every year for 15 years, meaning that he or she would have contributed a total of R495,000 over the period.

This is very near the current maximum R500,000 lifetime limit. I have used the highest tax bracket and allowable contribution expressly to try to provide an indication of what could possibly be the upper limit of the tax saving for individuals.

Graph 1 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 version of the Prudential Enhanced SA Property Tracker Fund that is not tax free (the identical fund but not inside 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).

The actual tax savings compared with unit trusts that are not tax free is dependent on a combination of factors, the primary two being your marginal income tax rate and the type and quantum of income and capital gains earned in your selected unit trust

Then, if the investor decides to sell all or part of the nontax-free investment, he or she will have to pay capital gains tax of about R244,000 on these gains, reducing the investment value to R1.74m and thus making 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.

On an individual basis, it is difficult to determine which types of tax-free investments would offer the most benefit.

The actual tax savings compared with unit trusts that are not tax free is dependent on a combination of factors, the primary two being your marginal income tax rate and the type and quantum of income and capital gains earned in your selected unit trust. The higher your marginal income tax rate, the more you will save in these types of vehicles.

At the same time, fund returns are taxed according to their source of income, resulting in different funds incurring different types of taxes.

In conclusion, when it comes to tax-free investing, start by developing a long-term financial plan for yourself and your family. Only once you have this in place should you start to optimise your plan for tax by considering all of the available investment vehicles.

And don’t forget to invest tax-free for your children as well.

• Hugo is MD of Prudential Unit Trusts.