Tax-free savings accounts – how to maximise the value of the tax benefit

The investment return and tax saving only became meaningful after 10 years

The investment return and tax saving only became meaningful after 10 years

With two tax year-ends since the launch of Tax-Free Savings Accounts (TFSAs) in South Africa, many advisors and clients are still debating the best way to maximise the tax benefits of TFSAs. What has not helped much is that most product providers, including life companies, banks, unit trust management companies and linked investment service provider platforms, have jumped on the bandwagon and launched TFSAs over the past two years. This proliferation of TFSA product options, with the accompanying wave of “good news” marketing material, have left many investors and advisors wondering how best to utilise a TFSA as one of a number of tax-efficient savings tools.

We discussed this problem with financial advisors, examining the different options available to investors.

A TFSA is not the only available tax-efficient savings option

The media hype about TFSAs appears to have blinded people to the fact that the first savings priority for any investor should still be their contribution to a registered retirement fund (either through their employer or via a retirement annuity). As a rule of thumb, investors should first provide for an adequate contribution to their retirement fund before taking out a TFSA. With the recently increased income tax deductions available to retirement contributions, the potential compounded tax savings from a client’s contributions to a retirement fund early on in their career dwarfs the tax benefits of a TFSA.

Secondly, investors should remember to use their annual tax-free interest exemption (currently R23 800 for individuals under age 65). At current money-market rates of close to 8%, and various other income funds offering close on 9% per annum (pa), South African investors can keep close to R300 000 in a fixed income fund before paying any tax on the interest earned. Ideally this allowance should be used to set up an investor’s emergency cash pool.

The tax benefits of TFSAs compound exponentially with time

When TFSAs were originally launched, many investors and advisors underestimated the extent to which the tax benefits on TFSAs would compound over time. This was because a TFSA contribution is not tax-deductible upfront like a retirement fund contribution, which makes it difficult to calculate the value of the tax benefit in rands and cents.

In addition, the limits placed on the lifetime TFSA contributions for an investor have the effect of further delaying the real tax benefit to the time when the investor uses their full lifetime contribution allowance.

These points are best illustrated by an example. In the graph below we project a TFSA’s fund values over a 20-year period on the following assumptions:

  • The investor contributes the maximum annual amount of R33 000 and this limit is never increased by treasury.
  • The R500 000 lifetime limit is never increased, and contributions cease when this limit is reached.
  • Assume a 10% pa investment return and inflation of 6% pa.
  • Further assume a roughly 50/50 split in investment return between interest and capital gain, resulting in an effective combined tax rate of 30% on total investment returns.
  • Figure 1- TFSA value projection split between contributions and investment return.

    From the diagram there are three points to note:

  • The investment return (the yellow bars) and the tax saving (orange line) take a long time to accumulate and only really become meaningful after about 10 years.
  • In the first five years the value of the tax benefit is incredibly small.
  • Yet after 20 years, the tax saving represents over 20% of the total fund value.
  • From a tax benefit perspective, it appears to not make sense for an investor to utilise a TFSA for an investment horizon of shorter than five years. This picture changes dramatically though after 10 years due to the well-known compounding effect of long-term investment returns.

    Lifetime TFSA contribution limits are precious – don’t waste them

    Current TFSA product rules, as set out by treasury, do not allow an investor to recover any part of the lifetime TFSA contribution limit if she dips into the TFSA assets to fund an emergency expense. Every time an investor uses part of her TFSA contribution allowance, that allowance is gone forever.

    Any redemptions from a TFSA therefore represent a waste of part of an investor’s lifetime contribution allowance — ideally something to be avoided.

    Investment portfolios should be consistent with investment horizon

    A final point to discuss is what represents the ideal investment portfolio for a TFSA. There are two key considerations when deciding on an appropriate investment portfolio:

  • As highlighted above, TFSA investments should be 10-year or longer investments, and portfolios should reflect this reality.
  • Since TFSAs do not attract income tax or capital gains tax, the risk/return characteristics of TFSA portfolios are neutral to whether returns come from capital gain, interest or dividends.
  • One way to simplify this problem is to evaluate different investment strategies with reference to a long-term return and volatility measure, and see how they stack up. In the table (below left) we do exactly that, highlighting the 10-year annualised returns and volatility statistics for a number of potential TFSA investment options:

    Figure 2- Fifteen-year annualised return/volatility for a number of TFSA investment options to 31 August 2017

    The graph illustrates what most of us intuitively already know — more conservative portfolio choices merely reduce the likely long-term investment returns without really adding anything. Similarly fixed income investments, while they might appear attractive as they attempt to maximise the value of the tax saving, will also disappoint in terms of their total long-term investment returns.

    A good starting point for most TFSA investors is to have a look at South African unit trust funds from the “ASSIA Domestic Multi-Asset: High Equity” or similar category. These funds have historically produced very attractive long-term risk return trade-offs, and work even better when tax does not affect the structure of the investment decision.

    One can comfortably move even higher up the risk curve, especially for longer investment horizons. The most commonly selected investment option for the Investec IMS TFSA for example, has been the Investec Global Franchise fund.

    Conclusion

    TFSAs are a great initiative from government to encourage savings in South Africa, and they are important tools for a financial advisor. However it is important to see them correctly — as long-term investments — in order to maximise the value of the client’s lifetime tax benefit.

    Jaco van Tonder is director of advisory services, Investec Asset Management