There’s a lot of talk near the end of each tax year about tax free savings accounts (TFSA). Social media is abuzz with photos and comments about maxing out the contributions. But what is a tax free savings account and what does it all mean?
What is a Tax Free Savings Account
A Tax free savings account (TFSA) is really just a special type of savings account that the government has created where the growth on your money is not taxed. Usually, you are taxed on all growth and interest earned on your savings. You won’t necessarily notice this though as there is a tax free portion of R23,800 for persons under the age of 65. This means that if your interest and dividends across all bank accounts and investments is less than this, you won’t pay tax on it.
If all your savings and investments are worth R200k and you earn interest of say R16k in a tax year, that amount falls below the limit and you won’t be taxed on it. But as soon as you go over that limit, you will be taxed on the portion above the limit. So if you earned R35k interest income in a tax year, you would be taxed on R11,200. The tax rate will vary between 15% – 20% depending on the source of the income (interest or dividends).
With a tax free savings account though, all income derived from the growth of your investment is non-taxable. As you can imagine, you won’t necessarily see any benefit initially, but over time and as your investments grow, this could be a huge benefit! It may sound amazing (and it is), but there are limitations which are important to understand.
How does the tax free savings account work?
A tax free savings account works much like any savings or investment account. You can have a savings account at a bank, a fixed deposit account or an investment account. You are however limited to a contribution of R36k per tax year, and over your lifetime, you may only contribute up to R500k.
That sounds simple enough, but there are some interesting points that are often missed.
– A TFSA is not for short-term savings
The contribution limit is calculated only on money you put in to the account. If you withdraw money, the contribution allowance is not reset. This means that if you contribute R36k at the beginning of the tax year and then withdraw R10k due to an emergency, you can not put that money back in. A TFSA is not well suited for a short-term savings goal and definitely not for an emergency fund. The contribution limits are precious and cannot be reset – ever. Maximise your benefits with your TFSA lifetime limit.
– You cannot play “catch up”
If you are unable to contribute the maximum allowed amount in a tax year (currently R36k), you can not simply catch up next year and contribute more than the annual limit. Contributing the maximum amount each year will mean that it takes 15 years to reach your lifetime limit. If you under-contribute in a year, you will simply take longer to reach your lifetime limit.
– Contributing too much is a bad thing
If you contribute too much to your tax free savings account, you will be heavily penalized. You will be taxed at 40% for the contributions that exceed the annual limit. This is very steep and should serve as a warning to keep track of your annual contributions! Don’t simply stash all your money in your tax free account without checking where you’re at.
Your TFSA provider can give you a statement at any time though detailing the contributions you’ve made.
Can you have multiple tax free savings accounts?
Absolutely! You can indeed have multiple tax free savings accounts. However, the annual and lifetime limits are applied to the sum of all your tax free savings accounts. If you have 3 tax free savings accounts at different institutions, the total contributions will be added up and count toward your annual and lifetime limits.
Is a tax free savings account worth it?
Yes, but it’s a long-term investment. Realistically speaking you will probably not see any tax benefit in the first few years of investing in a TFSA. It’s only when your overall interest and dividends income exceeds R23,800 in a tax year that you will see the benefit. Over the long term though, 15 years or more, you will see incredible tax savings as your money grows with compounded interest. In fact, the longer you keep your money invested, the greater the benefit will be!
Where to open a tax free savings account?
There are obviously many options to open a tax free savings account in South Africa; almost all financial institutions offer one. You will need to find one that suites you best.
Banks offer TFSA’s that earn interest, and also a fixed-term TFSA with slightly higher interest. These have lower risks as you won’t lose your capital in such accounts. However, over the long term (many years), it may not be the best option as growth in equity (stocks and shares) will usually outperform interest offered by banks.
Fund managers also offer TFSA’s in which you can invest in equity. Most fund managers offer a TFSA “wrapper”; a kind of account in which you can invest in multiple stocks and shares, and even in ETFs. You can invest in local shares or internationally, as long as the funds you choose are rand-based. Some institutions also offer tax free savings accounts with pre-determined holdings, much like a Unit Trust.
It’s not easy to say what the best tax free savings account is in South Africa. It depends on your overall investment strategy and what your expectations are.
I personally prefer a DIY-type option and have chosen a EasyEquities TFSA. This is a wrapper in which one can choose investments.
But, there are many options. Consider the growth possibilities, and the fees. Don’t just open any old TFSA and don’t get caught up in the misconception that this is a savings account, to be used for short-term savings. Remember that the true benefit of a TFSA is in the long-term tax savings! And by long-term – I mean many years! The longer you hold your investment, the greater the benefit!
Got any questions about tax free savings accounts? Feel free to contact me or reach out on social media. I’m not a financial adviser and won’t tell you what to do, but there is a great financial community on Twitter who will be happy to join a conversation and assist with questions.