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Incorporating a tax-free savings account into your investment portfolio

A TFSA can be a useful tool in your investment portfolio to achieve investment growth over a longer term.

The term tax-free savings account (TFSA) is a very broad term for a savings account which can take the form of a bank account, fixed deposit, money market fund, unit trust portfolio or ETF, and investors can choose to open up a TFSA through a bank, asset manager, life insurer or even a stockbroker.

They are tax-efficient in that no tax is paid on earnings or income, and are attractive investment options because they are not subject to regulatory restrictions in terms of how the money can be invested. The type of TFSA that you choose and its asset allocation is dependent on the purpose for which you have earmarked the funds, although generally speaking if you’re using it as a longer-term investment vehicle, you are likely to benefit from investing in growth assets rather than in conservative allocations such as bonds and cash.

Regardless of one’s income, a TFSA can be a useful tool in your investment portfolio with which to achieve investment growth over a longer term of around ten to fifteen years.

The purpose of tax-free savings accounts

The term ‘savings account’ is somewhat of a misnomer because a TFSA is in fact better suited to a longer-term investment horizon as the tax benefits are only realised over a longer period of time due to compounding interest. As such, TFSAs are suitable for investing towards your child’s tertiary education, saving for a long-term goal, or supplementing your retirement funding. Because of the way they are structured, they are not suitable for short-term savings or as emergency funding vehicles.

The tax benefits of tax-free savings accounts

Generally speaking, investors will be taxed according to the type of vehicle they are invested in. For instance, if invested in unit trusts, investors will pay interest tax on the amounts earned from bonds and cash, subject to an exemption of R23 800 for individuals younger than 65, and R34 500 for individuals older than 65.

If invested in equities, investors will be liable to pay dividends tax at a rate of 20% which is withheld by the entity before the balance is paid out to the investor or reinvested. Those who are invested in real estate investment trusts will need to pay income tax on the distributions they receive at their marginal tax rate.

Lastly, investors will need to pay tax on 40% of the realised gain of any investment, which is then included in the investor’s taxable income, subject to an annual exclusion of R40 000. This means that an investor will only need to pay tax on the 40% gain to the extent that it exceeds R40 000 in that tax year.

What makes TFSAs particularly attractive is that individuals can invest in various asset classes without having to pay income tax, dividends tax or capital gains tax on the returns. That said, bear in mind that your contributions towards a TFSA are not tax-deductible as in the case of retirement annuities, and any contributions made towards your TFSA are made with after-tax money – meaning that, from a tax-efficiency perspective, retirement annuities still take first prize.

The only tax you could be liable for is in the event of death where the balance in your TFSA would form part of your deceased estate and would be subject to estate duty. With the above in mind, it is always advisable to first make use of the tax deduction on RA contributions where individuals can invest up to 27.5% of their taxable income on a tax-deductible basis before investing towards a TFSA.

You may also want to consider using your annual tax-free interest exemption of R23 880 per year to reduce your tax liability before utilising a TFSA structure.

Contribution limits

Currently, individuals are permitted to contribute an amount of R36 000 per year towards a TFSA, with a lifetime limit per investor set at R500 000. Keep in mind that this lifetime limit only applies to the cumulative contributions you have made to the investment, and there is no limit to the growth that you can earn on your contributions. There is also no limit to the number of TFSAs that a person can have in their name, but it is important to note that the R36 000 per year limit applies across all accounts. This means that the total amount an investor can contribute across all their TFSAs in a single tax year is limited to R36 000.

Think carefully before setting up a TFSA in your child’s name as any contributions made towards this investment will be deducted from your child’s lifetime contribution and this, in turn, will affect their ability to save in future. Any over-contributions made in a tax year will be taxed at 40%, and it is therefore advisable that investors monitor their TFSA contributions closely to ensure that they don’t exceed their annual limits.

Also important to keep in mind is that any unused portion of your annual contribution cannot be rolled over to the following tax year. For instance, if you contribute an amount of R26 000 towards your TFSA this year, your unused allocation of R10 000 does not roll over to next year, and you will still only have R36 000 to invest next year.

Another attractive feature of a TFSA is that it does not require any upfront commitment to contributions, meaning that you can stop and start contributions, set up a regular debit order, or make ad hoc contributions to your investment at any stage. This flexibility makes TFSAs ideal for reinvesting your tax rebate, housing your annual bonus, or making ad hoc contributions as and when you earn a commission.

Withdrawals

While you can withdraw money from your TFSA as and when you choose, any withdrawals should be carefully considered because they are deducted from your lifetime contribution limit. For instance, if you have contributed R200 000 towards your TFSA and you withdraw R100 000 to pay for an emergency expense, you will only have R300 000 available to invest in future. Because of this, TFSAs are not ideally suited for short-term savings or emergency expenses as regular withdrawals will eat away at your lifetime allowance. When making withdrawals, your service provider will need to make your funds available within seven days, except in the case of a fixed deposit account which would require 32 days’ notice for withdrawals.

Transfer between TFSAs

Investors are able to switch between TFSAs, although they must be careful to ensure that their funds are moved directly from one provider to another provider. An investor may not withdraw funds from a TFSA and then reinvest them with a different service provider as this will be regarded as a withdrawal and the amount withdrawn will be deducted from your lifetime limit.

Fees

From a regulatory perspective, TFSAs must be transparent, fees must be reasonable, and no performance fees may be charged. The growth that you earn on your money is not limited and all interests, dividends and capital gains on growth assets are tax-free. Penalties on early withdrawals may vary from provider to provider, but may not exceed R500. For ease of administration, some providers stipulate a minimum monthly contribution of R500, so you will need to do your research in this regard.

Setting up a TFSA should never be done in isolation but rather as part of a well-structured investment portfolio designed to achieve a pre-determined set of goals. While there are significant tax benefits to be achieved through such a structure, optimal tax savings and investment growth will only be achieved if your TFSA is strategically set up with a full view of your retirement savings and discretionary investments.

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