TFSAs are the gymnasts of the retirement savings world

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At this point you may have heard the phrase “tax-free savings account” many times. The operative word in this expression is “tax”. They came into existence as a governmental incentive to encourage South Africans to save more — perhaps for retirement, but really just to save, period. They offer some tax relief since all interest accrued, capital gains and any dividends from these accounts are exempt from tax. Returns are duly enhanced because of the tax protection given.

With three tax year-ends since the launch of tax-free savings accounts (TFSAs) in South Africa, many financial advisers and their clients are still debating the best way to maximise the tax benefits of TFSAs. A proliferation of TFSA product options by product providers — including life companies, banks, unit trust management companies and linked investment service provider platforms — have flooded the market and published marketing material in which they attempt to differentiate themselves. In the process, they have often served only to confuse the market about what is actually a simple product. 

It is evident that especially younger investors are being persuaded to open TFSAs almost as ordinary bank accounts, uneducated as to the fact that what they withdraw is lost to them as a tax benefit for the rest of their lives, under the current rules. 

Will Finance Minister Tito Mboweni adjust the caps on tax-free savings accounts in the 2020/21 National Budget? (702.co.za)

This is due to the fact that Sars is balancing its tax incentive to persuade people to save, with a few rules around the investment.

Rules of engagement

“Cons” wouldn’t be the correct term for these rules, as they are really things to consider; none of these points are deal breakers, just things to be aware of:

• The TFSA incentive is to encourage new savings, so you won’t be able to change previous savings accounts into tax-free ones.

• You can only invest R33 000 a year (it was R30 000 when introduced), and R500 000 over your lifetime, so it is capped. Above that cap and there is a stiff penalty tax of 40% for contributions that exceed the limits.

• Unutilised contributions don’t roll over, so if you’ve only invested R20 000 in one year, the remaining R13 000 doesn’t roll over into the next year.

• Although you can withdraw money whenever you like from your TFSA, you cannot “replace” it by exceeding your R33 000 limit in any subsequent year. Withdrawals therefore reduce your lifetime cap — hence it shouldn’t be treated as a normal savings account.

• It is of no advantage to low-earning people who earn under the tax threshold and consequently pay no tax. For them, any savings account will be just as good.

• The reality is that on a relatively low cap of R33 000 and with a life-time amount of R500 000 you are not going to be able to draw any meaningful retirement income in the future.

• A Retirement Annuity (RA) is superior for those in a high tax bracket. If you’re a high-income earner and find yourself in one of the higher tax brackets, the tax deductions on RA  contributions can leave you better off than if you used a TFSA — especially if you will be in a much lower tax bracket once you retire.

On the other hand:

• You aren’t taxed on the account’s growth, and these returns don’t affect your contributions limit. If you earn R3 000 interest it doesn’t count as an additional investment.

• You can access it at any time, at any point in your life, unlike an RA which can only be accessed (without penalty) once you turn 55. The hinges of the door to your TFSA account are rather loose. You can take money out at any time. This is ideal for those who are seeking early retirement, because it means you can access your money at whatever age you need it. But it’s arguably not so great for those who lack discipline and may be tempted to dip into their investment when they’re short on the monthly bills.

• A TFSA is an investment account that holds some other investments: these can be unit trusts, ETFs (exchange traded funds) or even cash, and these investments will be protected from tax while inside the TFSA.

Invest for the long term

According to tax advisers, TFSAs come into their own when you have a long-time horizon, say at least 30 years, before you even think about drawing the funds. You also need to be cognisant of where the funds are going to be invested and not just sit on cash which earns less than inflation. Ideally, you should be investing in a low-cost fund where you are going to get maximum growth and maximum tax benefits, such as a property fund. In addition, you should only invest in a TFSA once you have made the maximum contribution to your retirement funds. And as with all savings schemes, the earlier one starts, the better the eventual return due to the magic of compound interest.

Investors should therefore carefully study the appropriateness of their selected TFSA, as switching between TFSA products is at this time not possible without it being viewed as a new contribution. If for example you have R10 000 invested in TFSA product “A” from prior years, and you would like to switch to TFSA product “B” offering higher returns, the process of switching will be treated as the same as a withdrawal and reinvestment, so that the annual contribution for the current year will be reduced by R10 000, even though it was invested in a TFSA before.

The idea is to save, not get fancy

While the caps ensure it is not meaningful to one’s retirement provision, the idea was always to encourage more savings (and more people to save) and not replace all other forms of saving. This it succeeds in.

The above arguments are for the more financially literate. As mentioned, the TFSA was introduced to persuade people who don’t currently save, to save. Among this sector, it appears that it has not been an enormous success. Many people in that category fall below the tax threshold, and in any case scarcely have enough money to pay their monthly expenses. Nonetheless, it has encouraged some new savers, even if the main market has become the affluent.

Persuading people to save when they can barely cover their monthly bills is always going to be a big challenge. Everybody knows the advantages of saving — in theory — and have every intention of putting it into practice one day. In this regard, any form of saving is beneficial, so there is no right or wrong choice.

TFSAs, for example, can be taken out for children as a means to inculcate in them from an early age the discipline of life-long saving.

However, TFSAs do have a few game-changers which may make them better suited for your goals than alternatives such as a RA:

• If you plan to retire early, you may prefer a TFSA since you won’t be allowed to access any money in an RA until you’re 55.

• Do you have a work pension fund? The tax treatment and rules around pension funds and RAs are quite similar. This means you already have a RA-type product through your employer and may want to consider a TFSA instead of an RA so you can diversify your tax treatment.

The great thing about TFSAs is that they are ideal to use in combination with other tax-deductible savings products, such as a retirement plan or a RA. There are no rules preventing you from having both. That way you can get the benefits of both types of retirement products. Going this route will also give you a lot of flexibility when you do retire.

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