Who wants to be a millionaire? Try a tax-free savings account

A tax-free savings account is the best investment you can make as a South African provided you follow the rules and employ them effectively, experts say. If you want to be a millionaire, this is the way to go.

We all know that if you have extra money sitting in the bank or an investment account, you will pay tax on the income or capital growth in one way or another. You may already know about capital gains tax, dividend withholding tax and tax on interest, Munya Shumba, financial advisor at Discovery Limited, says.

“It is all sliced and packaged differently, depending on where and how the money is earned, but one thing is certain: if you earn money or grow your capital, you are going to pay tax. Sometimes this can be a substantial amount too, but it is easier to accept reality than lament it.

“Fortunately, there are legal ways and smart ways that South Africans can reduce their tax bills. And then there is the tax-free savings account (TFSA).”

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Various ways to pay less tax

Shumba says there are a number of situation-specific ways to minimise your tax responsibilities generated from your savings or investment activities by applying specific solutions to your portfolio or needs.

“You will not completely eradicate all of your commitments to the taxman, but you should not pay more than you are legally obliged to either. The most under-utilised instrument is a hidden gem, the tax-free savings account.

“The possibilities of applying the right type of strategy to your tax-free savings account and its allowances are widely misunderstood and in most cases require patience or an appetite for risk to bear fruit. Once you understand and unlock the possibilities, your only regret will be not having started the journey to use it effectively sooner.”

Tax-free savings accounts were introduced in 2015 and are often misunderstood as an investment vehicle due to how it has been packaged and promoted in South Africa. It was introduced to encourage South Africans to save, an important endeavour when you consider that, across the board, we are not net savers, he says.

“This helps South Africans to avoid paying income tax, dividends tax or capital gains tax on the returns from TFSA investments, although we are limited to a maximum annual contribution of R36 000 and a lifetime limit of R500 000.”

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How people in the UK became millionaires this way

The UK version of the tax-free account is called an individual savings account (ISA) introduced in 1987 and the first ISA millionaire was made in 2003, a private investor by the name of Lord Lee. In 2023, there were over 4 000 ISA millionaires in the UK and its largest tax-free investment account sits at £8.5 million 37 years later.

Shumba says while the UK’s annual limits gradually increased from £2 400 in 1987 to £20 000 today, the growth within the account has been achieved to a far greater extent through the compounding effect of investing.

“This reveals the real function of a tax-free account. Unfortunately, it will not help solve the savings crisis in the country as is promoted. For 99.9% of South Africans today, putting R36 000 in a money market account will yield little to zero tax implications anyway.

“For the 0.1% where it would have an effect, they would owe the taxman approximately R1 296. Respectfully, if you sit in that 0.1%, this sum would be the least of your concerns.”

Shumba says the purpose of a tax-free account is to invest as opposed to save over the long term with the specific goal of becoming South Africa’s version of an “ISA millionaire” yourself. Your long-term proceeds can then hopefully be used to supplement your retirement income.

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How to invest in a tax-free savings account

In 2015 the initial annual allowance for a tax-free account was R30 000 per year and currently it is R36 000. The threshold was increased by an average of 2% per year since it was introduced. While you cannot assume that this trend will continue, it probably will over time.

You can invest in your TFSA in a variety of instruments:

• Fixed deposits
• Unit trusts (collective investment schemes)
• Linked investment products
• Exchange traded funds (ETFs) that are classified as collective investment schemes.

Shumba says if you started a brand new tax-free savings account today and place it in a fixed income deposit with a bank, you could get up to 8% a year return. At this rate, with compound interest it would take 28 years to accumulate up to R4.4 million.

However, if you are a clever investor and take some risk by taking advantage of local and offshore equities, you would benefit by exposing a portion of your investment to 99.6% of the global economy, through companies such as Google, Amazon and Coca-Cola, he says.

“Given that we are an emerging economy, you would also have the benefit of investing in a hard foreign currency, hedging any future depreciation of the rand over time against other major currencies. Historically, this has netted investors an additional 3% per year on average over the last 10 to 20 years.”

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Benefits of not paying tax

The tax benefit of not paying capital gains tax and dividend withholdings tax in your investment cannot be understated, he says. “Given how these investments have performed historically, investors have the potential to grow their TFSA investments to R4.4 million in just 22 years, six years earlier than a fixed-deposit investment.”

If you stayed the distance for 28 years, your capital could grow to R8.9 million over the same period, a 100% potential gain, highlighting the power of investing over saving.

“The R36 000 TFSA allowance should be the most aggressive investment in your portfolio. If you hit it out of the ball park you have zero tax liabilities. If it flops or returns a mediocre return on investment, you are protected given that your outlay is limited to R36 000 per year and R500 000 for your lifetime.”

Shumba says while you should never gamble with your savings or investments, this is the closest you can ever get to rolling the dice in a casino with very little down-side risk and an asymmetrical advantage to your benefit in the form of zero tax payable.”

South Africa does not have its first tax-free millionaire yet, but Shumba says for those who were fortunate enough to understand and implement this information in 2015, the largest tax-free account today sits at approximately R500 000.

“This account should reach the million rand mark by 2029. If you have not already started it, your journey should begin today. Five years from now, when the announcement is made parading our first achievers, the last thing you can ever say, is that nobody ever told you so.”

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How to master tax-free savings

Duma Mxenge, business development manager at Satrix, says investors should keep these critical considerations in mind when investing in a tax-free savings account:

• Mind the contribution limit: Annual contributions to your TFSA are capped at R36 000, while the total lifetime contribution may not exceed R500 000. The penalties for going over the limit are a hefty 40% of the amount exceeding the limit.
• Your TFSA is not meant for a rainy day: Investors must not treat a TFSA like an emergency fund to dip into when life happens. The tax benefits of a TFSA are maximised when the account is held for a minimum of 10 years. Your TFSA should rather be part of your longer-term financial plan. By contributing regularly, your TFSA will grow, benefitting from the magic of compound interest and substantial tax savings over time. Remember, you cannot reinvest any money you withdraw at a later stage as any funds you invest count towards your lifetime limit.
• Work with a financial adviser to build your blueprint:  A financial adviser can play a pivotal role in helping you harness the full potential of your TFSA investment. Instead of sporadic contributions, for example, a strategic monthly investment amount can lead to substantial long-term growth.
• Maximise your contributions: If you commit to contributing as much as possible to your tax-free savings account, you could reach your lifetime limit in just under 14 years. If you faithfully invest monthly, maximise your contributions and use the best investment vehicle and strategy for your needs, tax-free savings accounts can make a game-changing contribution to your future retirement.
• Keep it simple: In a nation with high taxes, leveraging every available tax break is essential. It is critical to make your money work harder for you.. ETFs track an index, giving clients a similar performance to the stock market over time. Multi-asset class funds are great for lower risk appetites as they help weather volatility.

Mxenge says armed with the right knowledge, even the most novice investors can create a path of sustained financial growth and tax efficiency. TFSAs have changed the game and continue to be a critical tool to empower investors to live with financial confidence.