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 (CGT) they have to pay. Had these investments been in a tax-free structure, no CGT 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 penalised and have to pay a tax of 40% on your contribution.

You also have a lifetime limit of R500,000 for tax-free investments. This is a further reason why you should not use a tax-free investment 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. 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%.

Using the above assumptions, the value of the investment would be about R1,060,852 once you hit your investment limit.

If your tax rate was 30%, the CGT you would have paid on that amount 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 a 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 summarise: 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 thirties they will have access to a tax-free lump sum that can really make a difference in their lives. DM

Kenny Meiring is an independent financial adviser. Contact him on 082 856 0348 or at financialwellnesscoach.co.za. Send your questions to [email protected].

This story first appeared in our weekly Daily Maverick 168 newspaper, which is available countrywide for R29.