The impact of tax-free investing is so astronomical that it’s almost hard to believe. Just a 0.5% saving on dividend withholding tax (DWT) over a 40 year period amounts to R1.1m more in your portfolio (in today’s money). That’s not to be sneezed at!

As of this year, each South African resident is entitled to invest R36,000 per year into a tax-free account. This allocation is available to everyone, including children and foreign nationals. This money, invested into a special tax-free savings account, is exempt from three kinds of tax: dividend withholding tax, tax on interest and capital gains tax (CGT).

Since our annual tax-free allocation was increased by R3,000 this year, we’re revisiting some of the basics of tax-free accounts in this post. 

This should be the first money you invest

Your tax-free allocation should be your first port of call when it comes to investing. The longer you are invested tax-free, the more tax you’ll save on interest and dividends and the more your money would have compounded for a CGT saving. If you don’t have enough money for a full retirement annuity (RA) contribution as well as a tax-free contribution, do your tax-free account first. This algorithm told us so and we’re not going to fight it, in case the robots end up taking over.

This is not for cash

The beauty of tax-free accounts is that you save tax on dividends and capital gains. Yes, you also save tax on interest, but the first R23,800 of interest all of us earn is tax-free anyway. At a 10% interest rate—not unheard of in even normal bank accounts at the moment—you need R238,000 in cash before you start paying tax. Since you can only contribute R36,000 per year, you would have to max out your tax-free allocation for almost seven years at a 10% interest rate before you start being eligible for tax on interest. Cash investments also don’t attract CGT, meaning you’ll miss out on that saving too.

If, on the other hand, you invest in an ETF that pays dividends, you start saving on DWT on day one. Your investment also has more time to compound. Since CGT is a tax you pay on the profit your investment makes, the bigger the profit in your tax-free account, the bigger the tax saving.

You should buy ETFs

Your tax-free account is best used buying low-cost ETF products. These products pay dividends and attract capital gains tax over time. If you’re still learning about ETFs and not sure which ones to buy, you can still transfer your R3,000 per month or R36,000 per year into your tax-free account while you decide. Remember, your annual tax-free allocation expires at the end of February every year. If you miss one year’s allocation, you will have to contribute one year longer to reach your lifetime limit of R500,000.

If you’re unsure where to begin, consider a global, broad-market ETF that gives you exposure to as many financial markets around the world as possible. If you don’t feel ready for the wide world, a Top 40 investment is perfectly fine too.

First in, last out

The more time you give your tax-free account, the more tax you’ll save and the more money you’ll get out. For that reason, you should leave this money as long as humanly possible. This is an invest-and-forget product that will be a welcome supplement to your retirement income. Contribute as much as you can, but don’t touch!

The allocation is an upper limit

If you don’t have R36,000 to save every year, don’t worry. That amount is the upper limit, which means you can contribute up to R36,000. If you only have R3,000 to contribute, that money will still work hard for you. Do it!