Tax-free savings FTW!
To celebrate Savings Month, we’ve been talking about ways you can save this July. Today, we’re looking at tax-free savings accounts (TFSAs for short). They were introduced in South Africa in 2015 and offer a tax incentive to encourage people to save. Saving is obviously critically important and something we could all definitely improve on here in SA. The more you have saved, the less you’ll rely on debt if you lose your job or if you’re faced with a large, unexpected expense.
So, what’s this tax incentive then? Well, when you invest in a ‘normal’ investment, you pay tax on the investment growth — interest, dividends and capital gains are just some examples. With a TFSA, the incentive is that you pay no tax! You’ll enjoy all the growth that comes from your TFSA, without having to give any portion to the tax-man!
Is there a catch?
Not really, but there are limits on much you can invest: up to R36,000 per year, until a maximum lifetime amount of R500,000. You can’t game the system by opening various TFSAs with different providers — you still need to stick to the overall contribution limits. In other words, if you open six TFSAs, you can only contribute R6,000 per year to each one to get to the total yearly TFSA contribution of R36,000.
If you contribute less than R36,000, the balance can’t be used to beef up your investment in the following year. For example, if you invest R33,000 in 2021, you can’t invest R39,000 in 2022. Be sure to keep an eagle-eye on your contributions. If you contribute more than R36,000, you’ll pay 40% tax on the amount over the limit.
Long-term is best
Because of the power of compound interest, a TFSA is an excellent long-term investment. Imagine you invest the maximum contribution every year for about 14 years, which will take you to the R500,000 lifetime threshold. Assuming you invested in an equity or balanced fund, which grows at a rate of about 10% per annum, your R500,000 contribution should now be worth more than R1 million. Leave it in the fund for another 10 years, and you’ll be looking at close to R3 million!
A normal investment might deliver the same returns, but you’ll have to pay tax on the growth beyond certain exemptions. With your TFSA, however, all of the money you make belongs to you.
Don’t withdraw too soon…
A TFSA shouldn’t be used for short-term saving, like for an emergency fund. You don’t have to be a certain age to withdraw from a TFSA, as with a retirement fund, but withdrawing does affect your lifetime contribution limit. Say you’ve contributed R400,000 and you withdraw R100,000, you can still only contribute another R100,000 tax-free before hitting your limit, not R200,000 as you might think.
Growth is generally minimal within the first five years, so any premature withdrawal is not only a forfeit of your tax benefits, but also a waste of potential investment returns.
How do I choose?
There are many TFSA providers, but not all TFSAs are the same. Any traditional investment product can be flagged as a TFSA, and TFSAs are available across various asset classes like cash, equity, unit trusts and more. Some attract penalty fees if you withdraw too soon, others don’t. It’s important to understand what type of TFSA you’re investing in — seek the assistance of a financial advisor if you’re not sure.
In short, a TFSA has a place in most people’s investment strategy, especially if you’re young and you’re just starting out on your money journey. Jump in on the ground floor and ride that investment elevator to the top!