When not to use a tax-free savings account

Cape Town - While Tax-Free Savings and Investment Accounts (TFSAs) do offer novel benefits, as with any other investment vehicle they are designed for a specific purpose and should not be viewed as a one-size-fits-all solution, according to Paul Leonard (CFP®), regional head of Citadel.  

In terms of a TFSA, you are entitled to invest up to R30 000 per year and your contributions are capped at a lifetime limit of R500 000. This will be reached in just under 17 years if you invest the maximum of R30 000 per year.

Leonard puts it in perspective:

When not to use a TFSA

TFSAs are not intended for short-term savings. You would only benefit meaningfully from the tax-free treatment of money in the TFSA once the value of the investment is sufficient to exceed the annual interest exemption and capital gains exclusion.

For instance, the current capital gains tax exclusion is R40 000 per year. If you chose investments with strong capital growth it could potentially exceed the capital gains exclusion within five years. Thereafter, you would be better off having this money in a TFSA than elsewhere.

Consider that the current annual interest exemption for people below age 65 is R23 800 per annum and this is not going to be increased in future. If you are younger than 65 and select only interest-bearing funds earning, say, 6% per annum, the fund would have to be worth R396 667 before the interest exemption is exceeded.

It would take you just over 10 years to reach those levels of investment in a TFSA if you invested R30 000 per year into interest bearing assets earning 6% per year.

When to use a TFSA

The use of tax-free savings and investment accounts is appropriate in the following circumstances:

- Achieving long-term investment goals;

- Saving for retirement when your income is below the income tax threshold, and you’ll consequently not enjoy any personal income tax relief from contributions made to retirement funds;

- Topping up retirement savings over and above the maximum amount per annum (namely R350 000) that one can receive tax breaks on. Given that most South Africans are under-funded for retirement, there is a need for most working people to play catch up and contribute more than the deductible limits in retirement funds.

It is generally recommended that investors make use of all the tax breaks available for retirement funding investments before using TFSA. This is in line with the government’s objective to “complement initiatives and incentives to promote retirement savings”;

- Saving for retirement when you are uncertain about your long-term income or job security and may therefore need to access the capital if you become unemployed;

- Saving for retirement if you are uncertain whether you will emigrate, in which case you may want to realise the investment to expatriate your capital should you leave.

"Income tax payers will benefit from this 'mini tax haven' in the long term as it will dilute their overall tax rate over their lifetime. Couples stand to gain a double benefit as a household if they both invest in TFSAs for the long term. This same principle applies to families: each member of a family (including children) can invest up to R30 000 per year, meaning that parents can invest in their children’s names for the long term," explains Leonard.

Consider, though, that each child has a R500 000 lifetime limit and if the parent uses some of the child’s lifetime limit then the child is denied the opportunity as an adult him/herself.

A minor or adolescent child is likely to be below the income tax threshold. This means that an investment in the child’s name is likely to be tax free anyway. In this case, then, there would be no additional advantage to using a TFSA. If the child withdraws the investment before he/she starts to pay tax, some of his/her lifetime limit has been wasted in a season of life during which they received no additional tax benefit out of having the money in a TFSA, says Leonard.  

High net worth (HNW) investors may find this especially beneficial should any additional wealth tax on investments be introduced in the future.

Even though a fully utilised TFSA (due to the annual and lifetime contributions limits) may form only a small proportion of an HNW portfolio, it would still dilute the HNW individual’s - or their family’s - overall tax rate somewhat and contribute to a tax saving nonetheless.