Adding tax-free investments (TFIs) to your portfolio is a wise way to improve returns while diversifying your risk. A popular investment strategy is to use your tax-free allowance to buy approved exchange-traded funds (ETFs). These funds give you exposure to predefined investment opportunities and sectors, but at much lower fees than traditional funds or direct share trading.

What are tax-free investments?

The tax-free incentive was introduced in 2015 to encourage South Africans to save for their future. You won’t pay any taxes that normally apply to investments when you save or invest in approved TFI products. So, you get to keep more of the returns your investments generate.

If you were to invest the maximum amount of R36,000 a year in a TFI every year, you would reach your maximum lifetime contribution of R500,000 within 14 years. We’re assuming that your investments grow at an average rate of 5% a year and that you receive dividend payments every year valued at 2.5% of your investments.

In this scenario, your contributions of R500,000 over the 14 years will have grown to more than R900,000 because the value of your shares increased by about R400,000. You will also have received dividends of R140,000 over this period.

Without the tax benefits, you would have to pay about R74,000 in taxes if your marginal tax rate is 28%. If you’re at the top end of the tax bracket, at 45%, this tax bill balloons to more than R100,000.

What tax-free products are available?

There are several options you can use to make the most of the tax-free incentive. These include tax-free savings accounts, tax-free unit trusts and TFIs that are available only as ETFs.

We’ll be focusing on the tax-free investments in this case because they offer better long-term returns and are all available on the Nedbank Online Share Trading (OST) platform.

An ETF is a simple and cost-effective way to invest in the stock market. These investment products are compiled by fund managers to give you a simple way to benefit from stock market growth without investing directly in the market.

For example, the Core Shares S&P500 ETF tracks the performance of the S&P500 index, which is made up of the top 500 companies listed in the United States. So, by investing in this ETF you’ll be benefiting from the share price performance of the likes of Apple, Microsoft, Amazon, Alphabet, Tesla and Johnson & Johnson.

With more than 70 tax-free ETFs available on the Nedbank OST platform, you can invest in funds that track only US stocks, or only mining and resources shares, or low-volatility shares. Your choices are almost limitless, and much wider than you can get from investing in JSE-listed shares only.

How to use tax-free ETFs to reduce your risk

It’s important to remember that you get the tax benefits only if you invest in a registered tax-free fund. Another quirk with tax-free accounts is that you have a lifetime contribution limit of R500,000 at a maximum of R36,000 per year.

This means that if you'd contributed R300,000, but withdraw R50,000, then you can only contribute another R200,000 in your lifetime, even though your contributions have fallen to R250,000 after your withdrawal.

However, this doesn’t prevent you shifting investments from one tax-free ETF into another tax-free ETF if you believe it will deliver better returns. Provided your money remains in your tax-free account, you can shift it from one registered tax-free fund to another. This is a useful way of reducing the risk of your investments, because you don't have to invest all your money in only one ETF.

Say for example, you had units in an ETF exposed to the resources sector. If you believe that the share price of miners had run their course in the immediate aftermath of the pandemic, you could then exit that to buy an ETF that is better suited to a high-inflation environment. And all the while, you don’t lose the tax-free benefits, provided you’re still investing in an approved tax-free fund.

Best of all, you can do this quickly, simply and cheaply on the Nedbank OST platform, which makes buying new ETFs or switching between funds incredibly easy and intuitive. All you need to do is sign up for an account, transfer funds to buy the investments you like, and continue to invest or trade between funds.

And unlike other investments, you have the satisfaction of not paying taxes on growth or dividends.