In March 2015, Tax-Free Savings Accounts (TFSA) debuted in South Africa as an incentive to encourage individuals to save more. TFSAs are often not used effectively, and the tax benefits not fully understood. Here are some guidelines on how to get the most out of your TFSA.
Don’t use a TFSA as a transactional account
Contributions are only afforded to you once. This means that you are not able to recover part of your lifetime contribution allowance (R500,000) should you make a withdrawal from your tax-free investment. When an investor uses part of their contribution allowance, that contribution is gone forever.
A long-term (+5 years) investment will achieve greater savings
Tax-Free investments are not designed for the short-term but rather for long-term capital growth. As there are no immediate tax savings, such as an upfront retirement fund deduction, the tax saving only really starts materialising after a period of five years or more (see our illustration below).
The graph below provides an illustration of the difference in expected future values and consequent tax savings between a normal unit trust investment and a TFSA over a 20-year investment period.
We assume the following:
- The maximum annual amount of R36 000 is invested at the beginning of each financial year and National Treasury never increase this contribution limit.
- Likewise, the R500 000 lifetime contribution limit is never increased, and contributions cease when this limit is reached.
- A return of 12% per annum is achieved.
- A return split of 80/20 between capital gains and interest, resulting in an effective tax rate of 21% on total investment returns if not invested into a TFSA.
- No withdrawals are made during the lifetime of the investment.
The outcome after a 20-year period is that an extra R630,868 is accumulated, purely from a tax savings perspective. It is evident that the longer the term of the investment, the wider the savings gap between a normal taxable investment and a TFSA.
The best way to use a TFSA
TFSAs should be used to supplement your retirement savings:
- At retirement, an individual will typically look to fund their desired lifestyle from an annuity, with the income being taxable at their marginal income tax rate. A well-constructed retirement plan will structure income from both discretionary savings such as a TFSA and annuities to mitigate taxes as far as possible.
- Structuring your retirement income from both discretionary savings and annuities will result in a more sustainable retirement plan and will allow for your money to last longer.
- Access to capital from an annuity in retirement is limited and having sufficient liquid capital is essential for any ad hoc or unforeseen expenses. A TFSA will provide additional liquidity.
- By using a TFSA as a retirement savings “booster”, you will naturally have a long-term focus and subsequently increase your tax savings.
A TFSA should not be used as an alternative to a retirement specific investment such as a pension, provident or retirement annuity but can rather act as a booster to your overall retirement savings. Speak to one of our portfolio managers to find out how to use a TFSA within your retirement plan.