How to Fire Up Your Tax-free Savings Account Efficiently
Recently, at a braai with family and friends, I asked who had money invested into a Tax-free Savings Account (TFSA). Of course, they weren’t impressed with my work talk and discussing taxes at a social event, despite me being passionate about this topic.
As a member of the financial planning fraternity, I understand how saving money efficiently can assist clients in the long run. After we discussed taxes for five minutes, as that was all the time I was given, most of them responded that they owned some sort of Tax-free Savings investment, either with an investment platform or a bank. Before I was removed from my soapbox, I managed to squeeze in one more question, and asked them if they understood how a Tax-free Savings Account worked? I received many blank stares and silence. We left the braai soon afterwards.
I am aware that people don’t want to discuss finances and tax, especially after the budget speech last week. However, people need to understand that a Tax-free Savings Account, if used correctly, can be one of the most efficient investment vehicles. There are a few misconceptions with regards to these instruments which prohibits many investors from fully benefiting from all they have to offer.
To maximise returns and investment experience, clients need to understand the dynamics of financial planning and products, this is where our role, as planners, is defined and important.
There are a few factors to consider:
There is an annual contribution limit of R36,000 and a lifetime limit of R500,000 to your Tax-free Savings Account. A mistake that some investors make is to over-contribute to their Tax-free Savings Accounts. Contributions over and above the annual allowable limit will be subject to a 40% penalty.
Since you can withdraw funds from your Tax-free Savings Account without any penalties, too many individuals use their Tax-free Savings Account similarly to a transactional savings account. The key differential is that there is no limit to how much one can re-invest into one’s banking account. Regarding Tax-free Savings Accounts, once you have reached your lifetime maximum allowance, you cannot top up again, regardless of withdrawals made.
Tax-free Savings Accounts are not constrained in any way, unlike retirement funds which must adhere to regulation 28 requirements. Therefore, another inefficient way to use a Tax-free Savings Account is to invest capital solely into money market and fixed interest assets. Your tax-free structure should be used as a long-term investment, and not as an emergency fund. With a long-term view in mind, one should aim to maximise long-term growth through exposures to high yielding, high growth assets local and abroad – the greater the longer-term growth, the sweeter the absence of associated capital gains tax!
Tax-free Savings Account in Your Child’s Name
Many clients want to give their children a financial boost into adult life, and this is a topic often discussed. Whilst the sentiment is endearing and the envisaged purpose noble, the benefit of tax-free investment accounts opened for children, unless used correctly, can be squandered. We see it often, parents open Tax-free Savings Accounts for their children and then make withdrawals soon after for school trips, school fees, holidays etc. Parents need to bear in mind that withdrawals from their children’s Tax-free Savings Accounts reverberate into huge tax losses, for their kids, into the future. If the investment is to serve shorter term financial needs, it is prudent to invest via a standard discretionary account.
Retirement Planning and the Benefit of Starting Early
If used correctly, Tax-free Savings Accounts can be used as an efficient retirement planning tool. If you contribute R36,000 every year, it will take approximately fourteen years to reach your lifetime limit of R500,000. Therefore, if you start contributing at age 30, you will reach your lifetime limit at age forty-four.
Assuming your investment portfolio within the Tax-free Savings Account, returns an annual growth rate of ten percent, your investment will be worth R3,160,708 when you reach a retirement age of fifty five. This lump sum can then be drawn, free of capital and income tax, or left to grow free of tax constraints.
Before I am thrown off my soapbox, it would please me knowing that you, our biggest asset, have a clearer understanding of how these investments work, and how they can best work for you.