The Tax Free Savings Account (TFSA) was introduced in 2015 by the government to encourage South Africans to save. As a nation we have a terrible savings rate, and the government does not have the budget to look after us in our old age.
How a TFSA works is that it is exempt of any taxes, including dividend, capital gains and income taxes. There are no limitations as to where the funds within the TFSA may be invested, nor are there any limits to withdrawals. This means that the output of your investment is significantly boosted, and you have the ability to withdraw at any point in time. However, it is subject to a maximum contribution limit, this being R500 000 over your lifetime or R33 000 per year (R2750 per month). Any contributions over this limit are taxed at 40%. The only tax that applies to a TFSA are estate duties, as upon your death the fund value of your TFSA is added to your estate, upon which the government levies an estate tax.
The TFSA was first adopted by the banks, typically offering fixed deposits and relatively low interest rates. Some banks have since adapted and now offer unit trust portfolios within the TFSA wrapper, thus increasing the opportunity for better growth over the long term.
The figure below shows the current status of TFSAs available through the five biggest South African banks. Fixed deposit and savings plan TFSAs offered through banks typically operate on a sliding scale of interest rates. The longer you lock your money away for, and the larger the amount which you have under their management, the greater the interest rate returned.
Figure 1. The various TFSA offerings by banks in South Africa.
Why use a TFSA?
The annual contribution limits of the TFSA mean that it is best suited for a long-term investment, as the effect of compound interest is far greater over long periods of time. Thus starting one as young as possible is an imperative. Fully funding your TFSA as quickly as possible means that you will reach your R500 000 lifetime contribution limit within 15 years. So it is something that is best started early, then left to compound for as long as possible.
The figure below illustrates the growth of a TFSA funded at R33 000 per year until R500 000 has been contributed. As you can see, the longer you keep your money invested, the greater the effects of compound interest are. The model below assumes a rate of growth of 12% compounded annually.
Figure 2. The contributions and total value of a Sharenet TFSA, projected over time. A growth rate of 12% per annum is assumed.
If you start contributing to your TFSA at age 25, it will be fully funded by age 40, at which point it could be worth around R1.25 million. By age 65 (retirement age), it could be worth R21 million.
Should you choose to invest your TFSA funds in a fixed deposit with a bank, you can expect to achieve more stable growth in the short term, as returns are typically guaranteed. However you may suffer reduced returns in the long term. This is because the underlying assets in which the Sharenet TFSA portfolio is invested in are equity and property denominated.
We believe that the TFSA is a long-term and thus aggressive investment, where capital growth is the main objective. The figure below illustrates the difference between compounding your TFSA growth by 7% annually vs 12% annually. The difference over 30 years is approximately 300%, with the gap increasing further over time.
Figure 3. Comparison of portfolio value between fixed deposit TFSA’s and the Sharenet Aggressive TFSA, over 30 years.
The aim of utilising a TFSA is to have a capital amount that you can draw a sustainable income from at retirement. The beauty of this is that it is 100% tax free. At retirement, income tax still applies, albeit starting at a higher threshold. Thus the value of tax-free money cannot be understated.
The charts below illustrate the income which can be drawn from a TFSA fully funded in 15 years and then compounded for a further 15. Two scenarios are presented in the chart. The first is a 100% recapitalisation rate of pre-retirement savings. This basically means you are not drawing an income from the TFSA, but are reinvesting the growth into a more conservative portfolio which is yielding 8% per annum. This is illustrated by the blue line on the chart. The second scenario is that of recapitalising 4% back into the TFSA to keep your capital growing, while drawing 4% of the growth as an income (figure 5). As you can see, after 30 years, the TFSA could provide you with an income of close to R300 000 per annum, completely tax free. This income increases annually as the capital amount of your investment increases. Alternatively, should you not wish to draw an income from your TFSA, you can leave it to grow further (blue line in Figure 4) and draw a larger income at a later stage.
It is important to note that your TFSA income should supplement any other retirement incomes that you have from other investments, such as your retirement annuity. It should not be your only retirement strategy.
Figure 4. A TFSA portfolio after 30 years, assuming a growth rate of 12% p.a. The investment is then adjusted to a more conservative portfolio yielding 8% p.a. The blue and orange lines represent growth rates of 8% and 4% respectively. The 50% growth portfolio is utilised to produce an income.
Figure 5. The annual income which can be derived from the 50% growth portfolio mentioned in Figure 4. Incomes derived from a TFSA investment are tax free.
How to make optimal use of a TFSA
Contributing R2750 per month towards your TFSA is the goal, as the sooner you reach the R500 000 lifetime limit, the sooner your money will work for you through the magic of compound interest. 15 Years is the minimum time frame in which you can currently hope to achieve this, based on current legislation.
The best way to fully fund your TFSA is by using it in combination with your Retirement Annuity (RA). As discussed in Part 5 of this series, contributing to an RA reduces the amount of tax which you are required to pay. The reduction is calculated based on the income tax bracket which you are in.
Thus contributing to your RA will result in a tax credit - I propose that this tax credit is invested into a TFSA.
My reasoning for this is that investing this tax credit anywhere else will result in a taxable event later on in life. The TFSA avoids this situation and allows you to keep the full tax credit and grow it at a compounded rate to enjoy later. Furthermore, this provides you with a portion of your retirement savings which can be invested more aggressively than that within your RA, and it can be withdrawn in its entirety should you wish to, without any tax payable or any penalties. This provides you with a greater degree of flexibility and a larger income at retirement which is subject to less tax.
How I use a TFSA in conjunction with a RA
Contributing to your retirement is a balancing act between future retirement income and today’s affordability. Thus utilising available structures which minimise your tax liability are the simplest way to achieve this.
The table below illustrates the tax deductions generated by RA contributions, in each tax bracket. To read the table, find your monthly income bracket is the left-most column, the next column to the right will indicate the tax bracket that you are in. As you move further right in the table you will see increasing RA contributions. Values in your corresponding tax bracket indicate the tax credit generated by the RA contribution. For example, a person who is right at the top of the 31% tax bracket, and who contributes the maximum allowable to his RA (R9407 per month) will receive a tax deduction of R2916 per month. Blue shaded areas indicate tax credits greater than R2750 per month (the full funding value of a TFSA). What must be noted is that the table indicates the maximum tax deductions allowable for each tax bracket. Your individual deductions may be lower. The simplest way to calculate your deduction is to multiply the tax bracket that you are in (eg. 31%) by your RA contribution.
Table 1. Monthly RA contributions and correlating tax credits, dependent on income tax bracket. Cells highlighted in blue indicate tax credits which are large enough to overfund a single TFSA on a monthly basis. Read the table from left to right. The cells under the 27.5% heading indicate the maximum allowable RA contributions within each tax bracket and the correlating tax credits.
RA and TFSA portfolios available
The Cautious portfolio aims to offer investment stability plus strong income comparable to cash in the bank. These aims will be achieved by investing in collective investment schemes available on the Glacier platform. The focus of the fund is to provide the investor with income while preserving capital against inflation over the medium to long term (3+ years). The underlying assets are primarily income driven. The fund will have low equity exposure close to 40%.
The Moderate fund aims to provide capital growth. Investors in this fund are prepared to tolerate moderate to high levels of fluctuation in the value of their investment and require a low level of income. These aims will be achieved by investing in collective investment schemes available on the Glacier platform. The recommended investment horizon is long term (5+ years). The underlying assets are a combination of equity, property and absolute return funds with a bias towards capital creation. The fund will have equity exposure close to 60%.
The High Growth portfolio aims to provide inflation-beating capital growth. Investors are prepared to tolerate high levels of fluctuation in the value of their investment and little to no income requirement. These aims will be achieved by investing in collective investment schemes available on the Glacier platform. The focus of the fund is growing wealth over the long term (5+ years) and the construction of the fund is tilted towards growth assets while retaining a proportion in income assets. The fund has a maximum equity weighting of 75%.
The Sharenet TFSA Fund aims to provide long term (5+ years) capital growth by investing in an aggressive asset allocation consisting mainly of local and offshore equities. Investors are prepared to tolerate high levels of fluctuation in the value of their investment and little to no income requirement. The fund invests in collective investment schemes on the Glacier platform that are approved for investing in a tax-free savings account. These investments do not charge a performance fee.
Move your existing bank TFSAs over to our portfolio and open an RA with us
As of 1 April 2018, the Treasury announced that TFSAs may now be transferred from one service provider to another, without triggering a withdrawal event. This means that should you have a TFSA which is invested with a bank, you can now move it over into a more aggressive/flexible portfolio.
The Sharenet TFSA is accepting transfers of existing TFSAs. Contact us today, and we will process the transfer for you.
Aside from boosting your savings for your retirement, a TFSA is a great place to save for your kids’ education. Starting one the day they are born, means you can fully fund it by the time they are 15 years old, and it could be worth close to R2 million by the time they are 19 years old. The interest earned off this investment could go a great way towards covering their tuition fees. The investment is held in your child’s name. This is a simpler and more affordable alternative to utilising a trust to pay for such events.
Maintaining a portion of your retirement savings in an available account
The best way to utilise your TFSA is to let it compound for as long as possible. This will maximise your returns. However, one fear that many people have when contributing to their RA is that the funds are not readily available, should they ever need them before they turn 55. Utilising the RA/TFSA combo ensures that you have a portion of your retirement savings in a vehicle which you can access at any point in time, without any penalties or taxes. This allows you to contribute a larger amount to your retirement savings than you normally would, as you can now have peace of mind that you can access some of the funds, should you need to.
If you wish to maximise your tax deductions and your retirement savings, contact Sharenet Wealth today and we will offer you an obligation-free consultation.
Ricki specializes in the field of wealth management with a focus on holistic financial planning. He has a keen interest in the investment fields of property, technology, precious metals and cryptocurrencies. Ricki also holds a Masters degree in Science from the University of Stellenbosch.