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Bump up your savings with a tax-free investment

11 September 2018 Mthobisi Mthimkhulu, Allan Gray
Mthobisi Mthimkhulu from Allan Gray.

Mthobisi Mthimkhulu from Allan Gray.

Have you taken the plunge and started your own business, but sacrificed some (if not all) of your savings to do it? Mthobisi Mthimkhulu suggests using a tax-free investment to boost your savings and preserve your tax benefits.

There is a growing trend among millennials (aged 18 to 40) to shrug off the security of a nine-to-five job in favour of the perceived freedom and profitability of being self-employed. A 2017 survey by Old Mutual found that hustlers and slashers – colloquial terms for people who make an income outside regular employment – make up 8% of millennials. But that percentage could quickly rise: Another survey by Deloitte found that 43% of millennials were ready to embrace the so-called gig economy, earning an income through freelancing and short-term contracts, but were held back from taking the plunge by a variety of reasons, including a lack of funds, courage and innovative ideas.
 
While addressing our high unemployment rate (which reached a 15-year high of 26.7% in May this year, with youth unemployment at a staggering 52.4%), this unencumbered work status brings its own set of financial risks.
 
Unlike permanent employees, who are often obliged to save for retirement in a company scheme, hustlers and slashers have no such obligation, or do not want the limitation of a retirement annuity, and retirement saving very often falls off the radar. Worryingly, the Old Mutual survey found that 68% of this group withdrew from their retirement savings and investments in order to fund their hustle.
 
Boost your savings
 
Withdrawing your full retirement savings to fund your small business dreams could set you back more than you think. Not only do you have to start saving again – you also miss out on the power of compounding, where the interest on your investment earns further interest, dramatically increasing your returns.
 
Another drawback is the tax implications. The South African Revenue Service has incentivised preserving your retirement savings with a tax-free allowance of R500 000 at retirement. If you withdraw prior to retirement, you will no longer receive this allowance or a portion of it.
 
In addition, you may not want to be tied down by the restrictions of retirement products as your business starts to grow. However, this does not mean you should forego planning for retirement.
 
You could use a tax-free investment (TFI) to boost your savings. With a TFI, you pay no tax on the interest, capital gains or dividends you earn, or on withdrawals. In addition, it is not as restrictive as a retirement product and you can access your money if you really need to.
 
But as with everything in life, there are advantages and disadvantages.
 
Tax-free gains
 
Take Andile Dube* (33). He resigned from his job to start a media business in 2017. He took the full cash benefit of his retirement savings, accumulated over 10 years at the same company, to fund his start-up. Andile is a diligent saver and also has a retirement annuity that he is not allowed to withdraw from until he reaches the minimum retirement age of 55.
 
When his business was up and running, Andile started thinking about how he could start saving again. Consequently, at the beginning of this year, he began contributing to a TFI, making monthly contributions of R2 750.
 
Our analysis shows that if Andile keeps these contributions up, he will hit his lifetime investment limit of R500 000 (that Treasury may increase – or decrease – in the future) in 16 years. Assuming his investment grows at 5.82% (the average rate of inflation over the past 16 years), the total market value of the investment would be R789 727 by 2034 – growth of R289 727. However, if he remains invested for an additional 11 years, until he retires at age 60, his investment could be worth R1 470 623 – completely tax free.
 
The drawbacks
 
An employer’s retirement fund and a retirement annuity remain ideal investment vehicles to save towards a comfortable retirement. Both offer annual tax benefits and are governed by legislation to minimise your exposure to high-risk assets that could erode your capital and compromise your income in retirement. You also have limited access to your investment to safeguard it from yourself, because you can never underestimate the temptation to dip into your savings when times are tough. Your retirement savings are also protected from creditors if you hit really hard times.
 
TFI products, in comparison, have several limitations. These are:
 
• Strict investment limits of R33 000 per year and a lifetime limit of R500 000. These limits apply to the total amount you contribute to all the tax-free accounts you may hold at different financial institutions. Any contribution above the annual limit will be taxed at a hefty 40%.
• A withdrawal you make does not increase these limits – that is, you cannot “replace” money you have withdrawn.
• Unlimited access – you can make a withdrawal at any time, which means, if you are not disciplined, you could deplete your capital and lose out on the magic of compound interest.
• Unlike a retirement annuity, a TFI is not protected from creditors. Should you default on any credit agreement, the court can make a judgement against your investment.

1. The goal of retirement savings is to provide you with an income when you can no longer work, but you cannot transfer funds from your TFI directly into a living annuity or guaranteed life annuity that would provide you with a regular income (within prescribed legal limits); you can only do so from a retirement annuity, pension or provident fund or preservation fund.
 
Despite the limitations, if you are disciplined and remain invested for the long term, a TFI can supplement your retirement savings and give you a tax-free lump sum to enjoy.
 
Speak to someone
 
It is a good idea to consult a good independent financial adviser. They have the experience and expertise to help you determine how much you need to save towards your retirement and develop a plan that meets your needs and investment goals.

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