The government introduced tax-free savings accounts (TFSA’s) in the 2015/6 tax year as a way to encourage South Africans to save more money. Since then, most financial services providers have added a range of tax-free savings products to their portfolios and many South Africans have embraced them as a tax-efficient way to invest.
Unlike retirement savings, a TFSA is a vehicle for saving or investing post-tax earnings and your contribution to such an account is thus not tax-deductible. You may not contribute more than R33,000 a year or R500,000 in total over your lifetime to a tax-free savings account, a threshold that has remained the same since 2015. It will take you 15 years of making the maximum annual contribution to hit your lifetime limit.
Money invested in a TFSA is exempt from capital gains or income tax. Your interest or dividends will be added to your capital each year without you losing a portion of those earnings to SARS. When you withdraw the tax-free investment, you won’t trigger a capital gains tax. Add this all together, and you can get an attractive compounded return over a 10- or 15-year horizon.
Though you are free to draw money from a TFSA at your own discretion, you may not top up any funds that you have withdrawn. The goal of this rule is to discourage people from taking money out of their TFSAs unless they really need to.
What all of this means in practice is that a TFSA is less tax-efficient for most mid and high earners than retirement funding, but more flexible. In exchange for sacrificing the tax deduction you would get for contributing the funds to a retirement product, you get the freedom to access your money whenever you want to or need to.
What’s more, tax-free savings products give you the freedom to invest all of your allowable annual contributions indirectly offshore or in equities if you wish. You can choose from a range of different products with differing risk profiles, depending on your investment goals. By contrast, you may only invest up to 30% of your pre-retirement funds (excluding living annuities) offshore and 75% in equities.
With all of that in mind, here are the scenarios in which we believe tax-free savings are most useful for a South African taxpayer:
- You can get an annual tax deduction of up to 27.5% of taxable income or R350,000 for your retirement fund contributions. If you have reached this limit, consider diverting some of your additional savings and investments to a TFSA.
- Taxpayers younger than 65 are exempted from paying tax on up to R23,800 in annual interest earned from a South African source; the limit for those older than 65 is R34,500 a year. If you exceed those limits most years, a TFSA can give you a small amount of tax relief.
- Due to the limited scale and long-term nature of tax-free savings, they are ideal for saving for your children or grandchildren. They are a simple, admin-free investment in the child’s name. If you start when the child is young, they will have access to a pot of money to put towards tertiary education, starting a business or a home deposit when they finish school. As indicated, the underlying investments are very flexible, not just savings deposit accounts, and thus the effective long-term growth can be substantial.
- For most high-income earners and high net worth individuals, TFSAs are by no means a game-changer. Nonetheless, when used wisely, they can help you to boost your savings and the wealth of your family over a longer time frame. We have found dollar-linked TFSA’s to be a particularly well-suited vehicle if you would like to send your children overseas for their education.
My next column will consider whether trusts still have a role to play in tax-efficient investment strategies.