Tax-free savings accounts (TFSAs) were introduced in South Africa in 2015 to encourage individuals resident in South Africa to save more. Over the past six years many product providers, including life companies, banks, unit trust companies and LISP investment platforms, have jumped on the bandwagon and launched TFSAs. This proliferation of options can be confusing, so how best should one utilise a TFSA as one of several different tax-efficient savings tools?
1. A TFSA is not the only tax-efficient savings option
A lot of the media coverage on TFSAs appears to take people’s eyes off the fact that the first savings priority for any investor remains their contribution to some type of registered retirement fund (via their employer or a retirement annuity). In general, investors should first provide for an adequate contribution to their retirement fund before taking out a TFSA.
Over the course of 2020, amid the impact of COVID-19 on the SA economy and markets, South African retirement funds were on the receiving end of some bad publicity. Specifically, the investment restrictions imposed on South African retirement funds via Regulation 28 attracted significant media coverage. The regulation limits equity exposure to 75% of a portfolio; there is a maximum limit of 30% in offshore assets and an additional 10% for the rest of Africa.
Many market commentators questioned whether retirement funds in South Africa still represent a good investment. Whilst this is an important debate for South African investors, it is a debate for a different article. Suffice to say that the tax benefits available to South African retirement fund investors remain significant. Especially when compounded over a period of twenty years or more, these benefits dwarf those of a TFSA. We remain convinced that retirement funds present good value to investors given the tax benefits.
Secondly, investors should remember to use their annual tax-free interest exemption (currently R23 800 per year for individuals under age 65). At current money market rates of between 4% and 5%, an investor in SA can keep up to R500 000 in a fixed income fund before paying any tax on the interest. Ideally, this allowance should be used to set up an investor’s emergency cash pool.
2. The tax benefits of TFSAs compound exponentially over time
When TFSAs were originally launched, many investors and advisors underestimated the extent to which the tax benefits on TFSAs would compound over time. This happened because, unlike a retirement fund, the TFSA contribution is not tax-deductible upfront. This makes it difficult to calculate the rand value of the tax benefits.
These points are best illustrated by an example. In Figure 1 we project a TFSA’s fund values over a twenty-year period based on the following assumptions:
- An investor contributes the maximum annual amount of R36 000, and this limit is never increased by National Treasury.
- The R500 000 lifetime limit is never increased, and contributions cease when this limit is reached.
- Assume a 10% per annum (p.a.) investment return and inflation of 6% p.a.
- Further assume a roughly 50/50 split in investment return between interest and capital gain, resulting in an effective combined tax rate of 30% on total investment returns.
Figure 1: TFSA value projection split between contributions and investment return
- From Figure 1 there are three takeaways:
- The investment return (the dark green bars) and the tax saving (burgundy line) take a long time to accumulate, and only really become significant after ten years.
- In the first five years the value of the tax benefit is negligible.
- After twenty years the tax saving represents over 20% of the total fund value.
- From a tax benefit perspective, it appears to not make sense for an investor to utilise a TFSA for an investment horizon of shorter than five years. This position, however, changes drastically after ten years due to the well-known compounding effect of long-term investment returns.
3. Lifetime TFSA contribution limits are precious – don’t waste them
Current TFSA product rules, as set out by National Treasury, do not allow an investor to recover any part of their lifetime TFSA contribution limit should they need to dip into the TFSA assets to fund an emergency expense. Every time an investor uses part of their TFSA contribution allowance, that allowance is gone forever.
4. The investment portfolio should be consistent with the investment horizon
There are two key considerations when constructing an investment portfolio for a TFSA investment:
- As highlighted above, TFSA investments should be ten-year or longer investments, and investment portfolios should reflect this long-term investment focus.
- Since TFSAs do not attract income tax or CGT, the risk-return characteristics of TFSA portfolios are neutral to whether returns come from capital gain, interest or dividends.
More conservative, fixed income-orientated portfolios merely reduce the likely long-term investment returns without really adding anything to the portfolio – since long-term investors should not be concerned about volatility.
Secondly, even though fixed-income investments seem attractive because they appear to maximise the tax benefit for the investor in the short term, they disappoint in the long term because of their significantly lower total returns.
It seems that a good starting point for most TFSA investors is to have a look at unit trust funds from the “ASISA South African Multi-Asset: High Equity” category, or something similar. These funds have historically produced attractive long-term risk-return trade-offs.
Given that TFSA investment portfolios are not restricted by regulation and are long-term in nature, investors with time horizons exceeding ten years should even consider more aggressive investment portfolios. The most popular investment portfolio for the Ninety One TFSA has been the Ninety One Global Franchise Feeder Fund, an offshore equity fund, which makes up 20% of total assets in the Ninety One TFSA product.
5. Keep it simple
Most large South African financial services companies have launched their own TFSA products, offering a range of options. Setting up a TFSA might sound like a daunting task. But it should not be – the best strategy really is to keep it simple.
There are several benefits to picking an investment platform, such as the Ninety One Investment Platform, for TFSAs:
- They offer a wide choice of local and international funds covering all risk profiles.
- Investors can simply switch between funds on the platform if needed, avoiding the need for messy TFSA transfers.
- Investors and advisors can monitor contributions to TFSAs centrally to ensure they do not exceed their annual TFSA contribution limits.
- Investors can easily see a consolidated view of their entire investment portfolio, which might include a retirement annuity and discretionary investments in addition to a TFSA.
TFSAs are a great initiative from government to encourage savings in South Africa and are important financial planning tools for financial advisors. However, it is important to set them up correctly as long-term investments in order to maximise a client’s lifetime tax benefit from the product. For more information, visit www.ninetyone.com/tfsa. DM/BM
This article was written by Jaco van Tonder, Director of Advisory Services, Ninety One