Investment product: Tax-Free Savings Account

The Tax-free Savings Account (TFSA) was introduced by the South African Government in March 2015 in an attempt to encourage South Africans to save more. Let us look at how this product works, what the benefits of this product are and when it is an appropriate investment product to use.

How does a TFSA work?

Every South African, including minors, are allowed to have a TFSA, meaning parents can invest money in their child’s name on their behalf. Each individual can invest a maximum of R36,000 per year (over the tax year that runs from 1 March until 28/29 February) and they are limited to invest a maximum R500,000 over their lifetime. If either of these two limits are breached, the contribution over and above the limit will be taxed at a rate of 40%. These thresholds are also increased by the government from time to time to keep up with inflation.

Usually, investments are subject to either Capital Gains Tax (CGT) on the growth of the investment or Income Tax on the interest they earn from an investment. Both these taxes eat away at the real rate of return of your investment. In a TFSA both these taxes are exempted, meaning that investments made in this product can grow without being hindered by taxes.

When is this an appropriate product to use?

Circumstances may differ, but the golden rule is that you should try to have between three and six months’ worth of your net salary saved in liquid form, such as in a bank account, to ensure you can pay for emergency events such as unexpected medical, vehicle or life expenses. This pot of money is usually known as your emergency fund. It is important to have some liquid assets otherwise your investment goals will be jeopardised due to withdrawals made from non-liquid assets when unexpected life events happen – as they undoubtedly will. You should also start saving for retirement via a retirement annuity, or a pension or provident fund.

Only when you have filled up your emergency pot and you have started saving towards retirement, can you start saving towards longer term financial goals, such as a holiday three years from now, a wedding, buying a car, or building up funds for educational purposes. For these saving goals, a TFSA may be an appropriate product as it does not limit the type of underlying investment that can be used, or the amount allowed to be withdrawn. As explained above, it can also grow at a higher rate as other savings products as it is not subject to taxes. Aim to maximise your allowed annual contribution to this product before starting to consider other investment vehicles.

How to make the most out of your TFSA

Let us first zoom out and understand that there are different options available as the underlying investments that can be made within a TFSA. This means that you can invest in Exchange Traded Funds (ETFs), unit trusts, global feeder funds or interest-bearing investments in your TFSA, to name a few. The important thing to consider is that you want to invest in an underlying investment that not only suits your needs best, but that also utilises the benefits of a TFSA the best.

The benefit of a TFSA is that the investment growth is not taxed. However, the amount that can grow unhindered by these tax constraints is limited, so to make the most of the benefit, you need to focus on two things to increase the growth of the investment. First, try to save in this product for as long as possible, and secondly invest in an underlying investment that can provide higher returns. As explained in previous articles, return is increased by taking on more risk, and the only way to take on more risk is to keep investments for a period of at least three to five years to ensure your investment is not exposed to short-term risks and volatilities.

Investing in shares locally as well as internationally can have the best payoff when following this approach. Shares can be accessed via a unit trust, ETF or a global feeder fund, depending on what is offered by the provider of the TFSA and what you believe suits your needs best. Although these higher risk investments are a good strategy to maximise the benefits of a TFSA, it is, however, not always the best suited for your needs. If you cannot keep the funds invested for at least three years or do not feel comfortable with a higher risk investment, consider investing in lower risk asset classes such as interest-bearing investments.

Where can I access a TFSA?

Most major banks and investment houses in South Africa offer TFSAs, but the underlying investment will be limited to what is available on their platform. Allan Gray, for example, will only offer the unit trusts that they manage as underlying to their TFSA. Different providers also charge different fees and it is, therefore, important to do your homework before deciding which provider’s TFSA you will use.