Should I transfer funds from a unit trust to a tax-free investment account?

Dear reader,

Firstly, let me begin with some information about tax-free investing.

There are different types of tax-free investment accounts depending on what you would like to invest in. Some financial service providers (FSPs) offer tax-free cash deposit accounts, which generate interest. Other FSPs offer tax-free share or unit trust accounts, which allow you to invest in unit trusts, exchange-traded funds (ETFs), or individual shares.

It is therefore possible to combine various tax-free accounts to create a diversified tax-free portfolio. Given this context, let us return to your question.

Is it wise to withdraw R36 000 a year from a unit trust and direct it to a tax-free investment account?

In short, yes, it is. Systematically transferring a portion of your investment into a tax-free investment account would increase your after-tax returns. However, the scale of the benefits will depend on a couple of factors.

Firstly, it depends on the underlying assets. If you are withdrawing from a diversified portfolio of unit trusts to invest in a tax-free cash deposit account, the benefits would be non-existent in the short run.

South African taxpayers receive an annual exemption from tax on interest of R23 800 (R34 500 for those 65 and older). If we assume you earned 11.75% on your cash deposit (the current prime lending rate), the balance of your account would need to be over R200 000 before you begin to reduce your tax bill. This would take you six years, given the R36 000 annual contribution limit.

Tax-free investments are thus more tax efficient when one invests in assets which generate higher returns, such as ETFs or unit trusts, as both dividend withholding tax and CGT are avoided. This brings us to the second factor, time.

There is a rule of thumb when it comes to tax-free investments.

The further the investor is from retirement, the better it will be to invest in a tax-advantaged account.

The more time your investment has to grow and earn dividends, the greater the reduction in CGT and dividend-withholding tax will ultimately be.

Finally, there are the costs involved with the investment.

The applicable fees depend on the type of tax-free account, your financial service provider, and on your financial advisor.

Tax-free cash deposit accounts typically do not charge any ongoing fees. Tax-free share accounts typically charge a brokerage fee on each transaction and may charge an ongoing administration fee. If you hold your unit trust and your tax-free account at the same institution, it is possible that this will reduce your administration fees. Lastly, there are the fees payable to your financial advisor. These are composed of an initial fee and an ongoing advice fee.

Tax-free investment accounts are a great way to increase the after-tax returns of your investments. The only downside to the accounts is the limits on contributions. It is thus a good idea to start contributing to your tax-free investment as early as possible or contributing to your children’s accounts, for that matter, as parents can invest on behalf of their children. Please note these contributions will count towards your child’s annual – and lifetime –limits.