Those of you with tax-free savings accounts (TFSAs) should be familiar with the annual and lifetime limits that apply. As it stands, there are severe penalties for contributing more than R36 000 to your TFSA in a single tax year and more than R500 000 over your lifetime.
In other words, you are allowed to exceed the limits, but the South African Revenue Service (Sars) will bring out its big 40% stick.
That means any money you contribute to a TFSA that exceeds the limits will be liable for 40% tax – so if you contribute R40 000 in a year, you will pay 40% of R4 000 = R1 600 in tax.
If you contribute R600 000 over your lifetime, that is R100 000 over your lifetime limit, so you will pay 40% of R100 000 = R40 000 in tax.
I think you get the idea.
On the other hand, there are some really great tax benefits: Sars won’t charge you any dividend-withholding tax, income tax, or capital gains tax on any money inside a TFSA. And when you view this great perk of a TFSA in light of the over-contribution penalty, it makes for an interesting dilemma ….
Is it worth it to take the upfront tax hit to score on the tax benefits inside the TFSA?
Of course, practically, you may not be able to exceed your annual limit (some TFSA providers stop you from contributing more than the annual limit to protect investors from accidentally over-contributing), but let’s assume you found a TFSA provider that would allow you to do it.
Let’s also assume that someone hadn’t made any TFSA contributions and happened to have the TFSA lifetime limit of R500 000 lying around waiting to be invested.
Would the tax penalty from contributing the entire R500 000 in a single year be offset by the tax benefit of having the money inside a TFSA?
It’s an interesting question, and it may also solve the complaint many older investors have around not being able to maximise the lifetime limit of their TFSA because they have fewer than 14 years of employment left (at R36 000 a year, it will take you around 14 years to hit the current lifetime limit).
Okay, let’s check this out by running two scenarios.
Someone with R500 000 to invest could either:
- Dump it all into a TFSA, take the tax hit, and let it run inside the TFSA without making any further contributions; or
- Phase the money into a TFSA at R36 000 a year until the lifetime limit is reached.
Let’s assume that in both cases, this person’s TFSA is invested in a diversified, equity-heavy portfolio that generates 12% per annum.
If this person puts the entire R500 000 in, it means they will exceed the R36 000 limit for that year by R464 000. This means they will be taxed at 40% of R464 000 = R185 600 (ouch!). Let’s also assume that they pay this tax hit upfront.
All this means that a total of R314 400 lands in the TFSA account.
Let’s check how that plays out versus a R36 000 per year contribution over 14 years:
At the end of 14 years, the investment balance of dropping the R500 000 in and paying the tax penalty is R1 536 508.
Meanwhile, phasing the money in R36 000 at a time leaves you with an investment balance of R1 301 589.
So throwing it all in and taking the tax hit leaves you around R235 000 better off – seems like a great idea right?
Not yet – there are still two more factors to consider ….
Firstly, it might be possible to pay the tax hit from outside of your TFSA account – in other words, you can make sure the full R500 000 hits your TFSA account (and not just the after-tax R314 400). In order to do that you would need R500 000 plus an extra R185 600 to cover the tax bill – a total of R685 600.
And there’s something else we overlooked in the previous scenario ….
If you did have the lump sum available to phase into a TFSA, you would add the R36 000 a year, but it’s unlikely that the rest of the money would just be sitting idle. No, it would probably already be invested somewhere else earning a return while it waited to be transferred into a TFSA. Not so?
So let’s assume the remaining money is invested in a similar asset allocation as the TFSA. Again we assume a 12% return, except this time it is subject to all those delightful taxes you need to pay outside of a TFSA – dividend-withholding tax, income tax and so on.
Dividend-withholding tax is a flat 20%, and let’s assume the portfolio’s returns include 2% from dividends; 20% of 2% means the returns lose 0.4% per annum to dividend-withholding tax.
Income tax is a little more tricky to account for since that will depend on your marginal rate and how much of your portfolio is in Reits (real estate investment trusts). So let’s estimate that it adds another 0.4% drag on returns. This leaves a total of 0.8% per annum lost to tax – meaning the non-TFSA money earns 11.2% per annum.
So now the two scenarios are:
- Take a lump sum and invest R500 000 into a TFSA at once, pay the tax hit of R185 600 for a total investment cost of R685 600; or
- Phase a lump sum of R685 600 into a TFSA R36 000 at a time, while the rest stays invested in a discretionary account earning 11.5% per annum.
Here’s what it looks like over 14 years:
Leaving the rest of the money invested now makes the tax penalty option pretty painful!
Phasing the money in leaves you with R3 109 685 versus the R2 443 556 you get after dropping it all in and paying the tax penalty. That leaves you around R666 000 (ominous!) better off by phasing it in.
Okay, so that covers the scenario up to 14 years, at which point the TFSA has been maxed.
But what about running it for longer – does the benefit of being in a TFSA kick in then?
Well, I extended the scenario to 100 years, and taking the tax penalty still leaves you worse off.
You just cannot recover from that 40% hit!
And finally, there is maybe still one more benefit of a TFSA that I have not considered – the fact that there is zero capital gains tax (CGT) payable on a TFSA when you sell.
It is highly unlikely that someone will just up and sell their entire TFSA at once (it’s far more likely that they’ll sell off portions annually once they hit retirement). But let’s assume they want to sell it all. Let’s also assume that they pay the highest CGT rate – 18%.
How do the ‘tax hit versus phasing it in’ numbers look now?
After 14 years:
Lump sum with tax hit – R2 443 556 (still the same; no CGT payable in a TFSA)
Phasing it in, CGT payable on discretionary investment – R2 784 228.
So it’s still better to phase it in.
And what about longer time frames?
Well, after 26 years or more, if you consider the CGT implication of selling the entire investment, you will be better off by taking the tax hit instead of phasing it in.
So does that make it worth incurring the tax penalty? In my view – no.
Unless you plan on investing it for over 26 years and you’re going to sell the entire investment and you will be bringing in more than R1 577 300 per annum in retirement (making you a 18% CGT kind of earner).
Till next time, Stay Stealthy.