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Do your homework before you invest in a tax-free savings account

Posted  March 4, 2019

February is tax month and you have probably been inundated with ads telling you to open a tax-free savings account (TFSA).

It sounds like a good idea doesn’t it? Who would want to use their hard-earned money to pay the Taxman? But not all these accounts are the same. This is what you need to know.

What are TFSAs? Although the name “tax-free savings account” suggests that this is an account that allows you to save money without paying tax, this may create the wrong impression.

TFSAs are not intended as short-term savings or transactional accounts
If you are likely to need the money in the next 12 to 24 months, a TFSA is generally not a good option. The tax benefit can be significant in the long run as compounding works its magic and your investment grows, but in the short term, the tax saving will be negligible. So a TFSA is probably not the right place for your day-to-day or emergency funds.

It may be helpful to rather think of these products as tax-free investment accounts.

Think of a TFSA as a trolley
Yes, the one you use to buy groceries for the week! It allows you to move your shopping around easily, but what you put in the trolley will depend on your budget, the size of your family and what you want to make for dinner. The same goes for a TFSA – it allows you to save and invest up to R33 000 per year into one or more accounts (in total) without having to pay tax on any of the proceeds (interest, dividends or capital growth), but the underlying investments (asset allocation) will depend on your personal goals and investment time frame.

You can invest up to R500 000 in total in these accounts over your lifetime.
If you invest the maximum R33 000 every year, it will take just over 15 years to reach this lifetime limit.

You can withdraw your money at any point, but if you’ve reached your annual contribution limit for the year, you won’t be allowed to top up the account until the next tax year and it will come off your lifetime contribution limit as well. For example – if you invest R33 000 on 1 March 2019, and withdraw R15 000 on 1 November 2019, you will only be able to invest funds again in the tax year that starts on 1 March 2020.

Make sure you don’t exceed the annual contribution limit
If you only have one account, the product provider will likely not allow you to invest more than R33 000 during a year, but if you have more than one, the providers wouldn’t know how much you have contributed to other accounts, so make sure you don’t exceed the annual contribution limit.

Since the product providers submit all this information to SARS, the Taxman will know and will levy a penalty of 40% on the excess contribution. (The money can grow beyond R33 000, as long as you don’t contribute more than R33 000 in any one year.)

What you need to keep in mind There are various options available
You can open a TFSA with a stockbroker, asset manager, insurer, bank or linked investment services provider (Lisp). A Lisp is basically an online store where you can buy a wide variety of unit trusts from various asset managers in one place. Examples include Allan Gray, Sanlam Glacier and Investec Asset Management.

Arguably the most important thing to consider is what you put in your trolley – in other words, what types of assets you put in the account. Although you cannot buy shares directly with a TFSA, you can include most unit trusts and exchange-traded funds (ETFs).

However, by far the most popular TFSA option has been to open cash or fixed deposit-type accounts with a bank, but be careful! Since the tax saving only really becomes substantial in the long term, most people should arguably rather invest most of the funds in these accounts in growth assets by using ETFs or unit trusts that offer exposure to shares and listed property. You could also choose a unit trust that invests in stocks, bonds, listed property and cash simultaneously or use different ETFs to get this type of exposure.

Asset managers are not allowed to charge performance fees in these accounts, so many managers offer their most popular unit trusts with the same underlying asset allocation, but at a flat fee within the tax-free account.

You already get an interest exemption of R23 800 every year
The government offers a tax exemption on the first R23 800 in interest you earn every year on cash, fixed deposit or money market investments that are not TFSAs. If you hold these types of accounts, and are earning 8% interest for example, you would only start paying tax once you had saved more than R297 500.

So if you haven’t used the full interest exemption in your non-TFSA investments yet, it wouldn’t make sense to invest in a cash-type TFSA. You are already saving the tax on interest!

For people 65 and older, the interest exemption is R34 500.

You are allowed to transfer your account between financial services providers
Since 1 March 2018, you can transfer your TFSA to another financial services provider, without it having an impact on your annual or lifetime contribution limit. Bear in mind, that the provider must do the transfer on your behalf directly. The money can’t be paid into your bank account. If it is, SARS will regard any money deposited into a new account as a new contribution.

The ability to transfer may allow you to access more competitive offerings (the number of TFSAs on the market have exploded since the introduction four years ago) but be careful to switch simply because performance has been disappointing. If the underlying asset allocation is appropriate for your personal circumstances and long-term goals, short-term underperformance shouldn’t be reason for transfer.

The bottom lineTFSAs are a great way to save tax in the long run but do your homework before you choose. You may end up saving less tax than you think.

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