Opening a tax-free savings account (TFSA) should be the first port of call for any first-time investor, but how do you choose which TFSA is right for you? Wessel Brand, Portfolio Manager at Sygnia Asset Management, has the answer.
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In Part 1 (3 Reasons a Tax-Free Savings Account Should be Your First Investment) I covered why TFSAs should be the first type of account any newbie investor opens. Building on this, I’ll outline 5 ways to choose a TFSA that’s right for you.
1 | Invest For Your Age
In general, your age determines your investment risk profile: the younger you are, the more risk you can take; the older you are, the less risk you can take.
While markets do rise over time, this doesn’t happen in a straight line – there are lots of ups and downs along the way. So if your investment timeline is longer, you can afford to take the occasional loss because this will invariably be made up by long-term gains. Whereas if you’re older you cannot afford to take a big loss shortly before withdrawing your investment for retirement.
This is why selecting a TFSA with low, medium or high risk according to your age is important.
2 | Select Assets According To Your Risk
Building on the above, the type of asset that underpins your TFSA should be determined based on your age risk profile, as different asset classes carry varying risk levels.
For example, if you’re young you can invest in higher risk Electronically Traded Funds (ETFs). If you’re older, it would be a good idea to choose low-risk index funds with wider exposure to the markets. These funds also offer added security in terms of being governed by Regulation 28, which means it has to be managed according to the investor’s best interests in terms of risk.
3 | Factor In Fees
This is because high fees chomp away at returns over time. A report by South Africa’s Treasury a few years back demonstrated how much high fees can cost investors; it found an investor paying 2.5% instead of 0.5% in fees will lose up to 60% of their retirement savings over a 40-year period.
Bottom line: if you want to maximise your tax-free investment over time, avoid high fees like the plague.
4 | Avoid Fixed Interest Vehicles
Most banks offer money market or other types of fixed interest accounts as TFSAs, but investing in these types of accounts is a waste of your tax-free investment allocation.
Let me explain: with an interest bearing TFSA your only form of growth is interest, therefore the capital invested will stay more or less the same over the years, and there is no way your capital investment can grow aggressively.
Added to that, interest earned on fixed interest accounts is tax-free up to R23,800, regardless of whether it’s a TFSA or not. Unless you have around R350,000 to R450,000 invested, you’re not going to hit that interest annual cap. So my argument is that putting your tax-free allowance into a fixed interest account is a waste of an opportunity grow your capital via an investment fund-based TFSA.
5 | Know Your Appetite For Risk
While low risk TFSAs naturally have less volatility than high risk TFSAs, this doesn’t mean there is no risk: there will always be a certain level of market volatility in every fund.
The trick is to know yourself and select a Tax-Free Savings Account according to your ability to handle the ups and downs. For example, you may be young and able to invest in high-risk funds, but if you’re the type of person who gets stressed out by unexpected financial changes it’s best you choose a low- to medium-risk TFSA.
Those are the five most important considerations when selecting a TFSA that suits your personality and your investment goals, but here’s one more important thing to bear in mind: tax-free investing is not a short-term strategy, nor will any investment grow in a straight upward line. You’ve got to be in it for the long-term to maximise the returns on your tax-free savings allowance. That means you need to commit to the TFSA you’ve chosen and then forget about it until you’re ready to cash-out, because with tax-free investing it’s all about time in the market, not timing the market.