Savings Month: is a tax-free savings account a good idea?

It is Savings Month and if you want to start saving, it is important to know if you should do so in a tax-free savings account as it seems like the ideal vehicle, regardless of your goal or time horizon, because the returns are tax free.

However, there are a few considerations when it comes to having a tax-free account, says Ester Ochse, product head at FNB Integrated Advice. “The tax-free savings account was created due to South Africa’s low savings culture. It is internationally recognised as a savings and investment vehicle created to foster a culture of savings in South Africa.”

Ochse says you should keep this in mind when opening a tax-free savings account:

Stay within the contribution limits

If you contribute within the limits, the growth of your savings account is tax-free, but if you exceed the limit in a year, it will attract a tax rate of 40% for that year. “The contribution limits are at the customer’s level and not at the account level and therefore you have to be especially cautious when contributing to multiple tax-free savings accounts. It may be better to have only one of these accounts to make it easier to manage, as well as truly able to leverage the compound interest effect.

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Try not to withdraw from your tax-free savings account

A tax-free savings account is not a transaction account and should not be used as one. Ochse says the idea is to add funds and let them grow over the long term. “When you contribute to a tax-free savings account and then withdraw from it, you cannot “top up” again as the original contribution is counted towards your lifetime contribution.”

If you contributed R72 000 to a tax-free savings account, for example, over a period of 2 years and you withdraw R20 000 for an emergency, it is still deemed that you contributed an amount of R72 000.

However, later, when you decide to put the R20 000 back, it is considered an over-contribution and could be taxed at the 40% rate. Rather leave contributions untouched to take full advantage of your account.

A great long-term investment vehicle

With the benefits of growth being tax-free in this kind of account, it makes it the ideal vehicle to consider as an add-on for retirement savings. However, remember that it is not a retirement vehicle and can only be used to add to your retirement nest egg, which may include your company pension fund, preservation funds or retirement annuity.

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Make sure that your actual investment is also long-term

Ochse says a tax-free savings account can contain multiple product types to allow you to invest across multiple asset classes, such as cash, unit trusts and shares. Therefore, when considering this kind of account, decide what your goal is with the investment and when you will use the funds.

“If it is a longer-term goal, such as supplementing your retirement funds in more than 15 years, consider exposure to more growth-type assets, such as unit trusts or ETFs that have a higher exposure to growth type assets, such as property and shares.”

She says cash investments should rather be used for shorter and low-risk investments as they will most likely underperform inflation over the long term. However, the cash investment option can be suitable for retired clients seeking low risk guaranteed returns and would help minimise the taxable interest income by investing in a tax-free savings account cash offering.

Opening a tax-free savings account for your child

Ochse says this is an interesting debate and again comes down to what your intention is. “If you open one in your child’s name, you use your child’s lifetime contribution limit. It can be very powerful if the idea is to supplement the child’s retirement, but if it is to pay for high school fees, it may not be the best option. With a sizable tax-free investment portfolio available to them once they turn eighteen, you can offer your children a head-start in life.”

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A powerful investment vehicle

A tax-free savings account is a powerful investment vehicle when used correctly, Himal Parbhoo, CEO of FNB Cash Investments, says. “It is a great solution to add to your long-term investment strategy. You can contribute an amount of R36 000 per year to a lifetime limit of R500 000 in this vehicle and the growth on that is tax-free, regardless of whether that growth is from compound interest, dividends or capital.”

For example, if you are a 30-year-old that contributes R3 000 per month specifically into a high growth portfolio that targets CPI +5% and leave it to grow until the age of seventy, you would have contributed an amount of R500 000 by the age of forty-five. But instead of drawing it and using it, you leave it to supplement your retirement. When you turn seventy, the investment will be worth about R12 300 790, which you can then use tax-free.

“Many young people have been using tax-free savings accounts over the past few years to take advantage of all the benefits because they know they will not have to pay income tax, dividend tax, or capital gains tax on the returns.

“This is fantastic for South Africa because it instils the culture of saving and investing at a young age, which leads to wealth creation and financial independence,” Ochse says.