Tax-free savings account still the best way to save

A tax-free savings account is still one of the best ways to save to reach your long-term financial goals.

“This is an incredible gift if used to its maximum. Just picture how powerful the compound effect of tax-free returns can be over the long term,” Abigail Wilson, business development manager at Morningstar South Africa, says.

A tax-free savings account (TFSA) allows you to invest up to R500 000 over your lifetime into various asset classes without having to pay income tax, dividends tax or capital gains tax on the returns from the investment.

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However, Wilson points out that apart from the lifetime contribution limit of R500 000, there is also an annual contribution limit, which is currently R36 000 per tax year. And although you can have more than one TFSA, the total of your contributions to all of them cannot exceed R36 000 per tax year and R500 000 in your lifetime. If you contribute more than that, you will be penalised and taxed at a rate of 40%.

Wilson says you can maximise the benefits of your TFSA by viewing it as a long-term investment, starting early, making alternative arrangements for emergencies and have sufficient exposure to growth assets.

Tip #1: View it as a long-term investment

Wilson says it is unfortunate that the words “savings account” is included in the name of the TFSA product, as most individuals would associate this with something that is short-term in nature and use it to fund unexpected expenses.

In an ideal world, we would rename it “tax-free investment account” as the word “investment” implies a nest egg left to grow for the long term. However, she points out, there is no limit on the number of years you can let your TFSA grow and compound.

“We view the TFSA as a long-term vehicle, as the real magic, which is the compound effect of the tax saving, is only felt after extended periods of time. The tax benefit accrued from investing in a TFSA is highly dependent on your income tax bracket.”

She says this is illustrated in this chart, which compares the returns generated over time from a TFSA versus a normal (taxable) unit trust:

The chart is based on the assumptions that your annual contribution at the end of each year is R36 000, with total contributions achieved after 14 years of R500 000, an effective tax rate on returns of 30% and an annual return of 10%.

She says the chart shows that in the short term the effect of the tax saving is not very significant, but from about year 15 onward the return differential between a TFSA and a normal taxable unit trust starts to widen.

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From year 20 it starts looking pretty decent and over a period of 30 years, the cumulative difference in returns is substantial. After 30 years, the TFSA in this example grows to a value of close to R4.8 million, while the normal unit trust that was taxed ends with a value of just over R3.5 million.

“And who does not want an extra R1.3 million? That is a pretty awesome gift from the government.”

Wilson says the lesson here is that if you have an investment goal of less than 15 years, you should perhaps consider using a different vehicle such as a normal taxable unit trust or endowment, rather than wasting your TFSA benefit on a short-term goal. The TFSA vehicle is most beneficial when you allow it to compound for more than 15 years and ideally 30.

Tip #2: Start early

Although there is a limit to the amount you may contribute to a TFSA, there is no limit to the number of years you can leave this sum to compound in value, earning tax-free growth. The earlier you start contributing, the sooner you can fill up your TFSA pot and the harder that R500 000 will work for you.

Wilson says if you invest the R36 000 maximum contribution each year, it will take 14 years to reach the R500 000 lifetime contribution limit and thereafter you want to leave the investment for as long as you can to really let the gap widen. This makes the TFSA an ideal discretionary supplement to your retirement savings.

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If your budget does not permit the maximum contribution, a lower contribution is still better than delaying contributions completely, Wilson says.

“Apart from starting at an early age, if you start early on in each tax year, it can also make a difference. If you can contribute a R36 000 lump sum at the beginning of each tax year you give this sum a 12 month head start on earning compound interest.

“Another option is to implement a regular debit order of R3 000 per month to help you ensure the consistency of your contributions. This is still more effective than contributing your lump sum at the end of the tax year.”

Tip #3: Make alternative arrangements for rainy day

Wilson warns you should not be fooled by the liquidity a TFSA offers. “Although the product allows practically immediate access, you do not want to use it as your emergency fund. TFSA product rules stipulate no minimum investment term and therefore no restrictions on access apply.

“This means you can request partial or full withdrawals at any age and these withdrawals will be tax-free. However, this does not mean that withdrawing is without consequences, as with any contribution that you subsequently withdraw, you forfeit your right to re-contribute.

Tip #4: Have sufficient exposure to growth assets

While risk tolerance is a key factor to consider when selecting the appropriate asset classes for your investment, so too is time horizon, Wilson says. If you are maximising your TFSA by giving it a 15 year+ time horizon to grow, you will gain the most benefit from having significant allocations to growth assets such as equities based on the long-term outperformance of equities versus more conservative allocations such as cash and fixed income. 

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