According to research conducted by Trading Economics, South African household savings rank the lowest compared to all other countries in the G20 group, and at the beginning of 2019 the average South African household was only saving 0.15% of its income.
With this in mind, the Minister of Finance introduced a new investment product known as the Tax-Free Savings Account (TFSA) in 2015. The aim was to encourage people to save. Since it launched, most investors have taken advantage of the tax benefits offered by the product. However, for many investors there is still a lot of uncertainty around how TFSAs work, and unfortunately many are not using these products in a way that will maximise their investment benefits.
Let us start off by considering the good news first, the tax advantage. Unlike your other investments, when you sell any investment within the TFSA you will not pay any capital gains tax (CGT) on the growth, nor any tax on the interest or dividend income received. This means that the growth of your investment is not hindered by any of the taxes that are usually taken into consideration for the rest of your portfolio. The impact of this is clear when you consider how CGT affects a standard investment. Forty percent of the growth of a normal investment will usually be taxed along with your annual income, based on the tax bracket in which you fall (the first R40,000 of investment growth per year is exempt from CGT). When it comes to dividends, 20% of the dividend income you receive as an investor is usually withheld and paid to the South African Revenue Service before you ever receive it.
It is, however, important to keep in mind that you can only invest R36,000 towards the TFSA annually. The maximum you can invest in this product, per person, over your lifetime is R500,000. Should you invest more than these limits, 40% of the income you earn from these excess investments will be included in your taxable income, so try and avoid doing that. The reason for these limits is that the product is not meant to be used as a means of avoiding tax, but rather to encourage saving.
Considering the above, it is now worth discussing the strategy that will help you to maximise the benefits of a TFSA. The key is to try and invest as much money in the product, as early as possible, and then not to make withdrawals from these funds in the short term. Young investors are usually encouraged to start filling up their TFSA before making other discretionary investments, to allow the investments within the product to grow as long as possible. The tax benefits are naturally enhanced the longer money is invested.
Importantly, the R500,000 limit over your lifetime is fixed, regardless of the withdrawals made from the product. Therefore, the goal is to preserve the funds you have invested into your TFSA and allow them to grow. If you are then going to invest in a TFSA over the long term, go a step further and up the risk in the product by investing in equity funds (i.e. funds invested in shares listed on the JSE and other exchanges) rather than more conservative asset classes such as cash and bonds. Equity has proven to deliver a higher return over longer periods compared to other asset classes, but the price paid for these higher returns is that, in the short term, the value of your investment will fluctuate substantially (and may even at some points be less than what you invested). However, holding on to your TFSA investment over the long term will in all likelihood boost the growth in this product because you will be compensated for the risk taken.
A key point to remember is that a TFSA should not be used as a piggy bank. Don’t deposit money in the product and use it a few months later to buy your friend a gift. If you know you will need funds in the short term, rather invest some money into a money market fund where it will earn interest, without depleting your lifetime TFSA limit of R500,000.
Finally, the first R23,800 interest a South African under the age of 65 years earns each year is also not included in their taxable income, even if not invested in a TFSA. So, I would advise you to chat to your advisor to structure your portfolio to take advantage of this savings strategy.
As Mahatma Gandhi famously said, “Your future depends on what you do today”. This holds true, not only for your health, career, relationships and investments but also for the habit of saving, and all the better if it is tax free.
Written by: Citadel Advisory Associate, Charné Olivier