TFSAs: the basics
Whether it’s for your retirement or the wedding you’ve always dreamed of, using a tax-free investment will help you get to your goals faster
On 1 March 2015 the regulations that allow for tax-free savings accounts were introduced. South Africans are able to save up to R30,000 a year in designated tax-free savings accounts (TFSAs). A
lifetime limit of R500,000 of contributions also applies, which would take about 17 years to reach if you contributed the full
amount each year. Savers can withdraw at any time but that does not affect the limits: new contributions are still subject to the annual and lifetime caps.
Regulations also cover what kinds of accounts can qualify as TFSAs and how they should be managed. Broadly, the rules ensure that TFSAs are low cost, do not take on excessive risk and provide maximum flexibility for savers to be able to withdraw or switch between accounts.
The regulations stipulate that qualifying products should be simple to understand and transparent in their disclosure. They may have no restrictions on the level of returns paid to the
individual or on when returns are paid out. Performance fees are not permitted and derivatives can be used only to reduce the risk of loss or to reduce costs – they cannot be used to increase risk (gear the investment). The regulations allow for five different types of TFSA:
1. Cash accounts
Making up more than 50% of all accounts opened during the first year of TFSAs, cash accounts have proven to be the most popular form of TFSA. Some take the form of fixed-term deposits but
most are call accounts allowing investors immediate access to funds.
Rules prohibit TFSAs from being issued as transactional accounts, to eliminate the risk of savers using the accounts for day-to-day spending. They also stipulate that all savings must be available within seven days’ notice. In the case of fixed deposits
however, banks can charge penalties for early withdrawals.
The chances of losing your investment through a cash TFSA are minimal with the returns usually guaranteed by large
institutions such as banks. However, the returns are generally lower than those of the other types of accounts, especially
while interest rates are low. The highest interest rate offered by banks is 8.94% from African Bank for its 12-month fixed deposit. Most financial institutions offering cash TFSAs do not charge any
Cash TFSAs are generally more suitable for short-term goals such as a deposit for a new house.
2. Stockbroker accounts
Typically, investors open an account with their stockbroker and use it to invest on stock markets through various eligible
exchange-traded funds (ETFs). These are low-cost index trackers – for example, they can invest in the stocks that make up the top 40 companies on the JSE, or in financial or industrial stocks, or even in foreign companies. They can also invest in other asset classes such as bonds and property.
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ETFs work on a similar basis to unit trusts in that investors buy into a pool of stocks. However, each ETF is listed on the JSE and acts the same as any other stock – you can buy or sell it at will.
Stockbrokers charge brokerage each time ETFs are bought or sold and the ETF also charges an annual management fee. Most brokers have kept commissions very low at about 0.25%, while the ETF management fees are usually about 0.5% per year.
There are about 40 eligible ETFs on the JSE. The most common and cheapest are funds tracking the JSE’s top 40 index. Once you have opened an account you can trade between ETFs or build a portfolio of different ETFs. These represent a low-cost way to get maximum risk exposure.
Stockbrokers also offer discretionary managed portfolios where the broker assembles a portfolio of ETFs or shares on your behalf.
The relatively high short-term volatility (price movements) and higher returns associated with investments on the stock market make these accounts the ideal tool for long-term wealth or capital accumulation.
3. Unit Trusts
While many fund managers offer collective investment schemes (or unit trusts as they are commonly called) directly to investors as TFSAs, some large fund managers have not yet entered the
market with products.
Unit trusts provide access to a variety of asset classes, investment strategies and risk levels. Through them you can invest in local and international assets, equities, money markets, property, commodities, bonds and a mix of all of these.
Unit trusts are usually actively managed by fund managers who make decisions over what to buy and sell. Their performance is usually compared against a benchmark, such as an index, or other measure such as inflation, that the fund aims to outperform. However, some are also index trackers, similar to ETFs, where they invest in a set of pre-determined counters.
Fees are usually higher than for ETFs because of the costs of active management. Most tax-free products do not charge any
upfront fees but annual fees can add up to around 2% of the fund, with money market and bond funds tending to have
lower fees. Fees are quoted in terms of the “total expense ratio” which captures all costs to investors in the most recent year.
Depending on the underlying funds and objectives, unit trust are ideal for both short and long-term investing.
4. Life insurance policies
With a life insurance wrapper you can invest in various funds offered by life insurance companies.
The advantage of a life policy structure is that it is simpler to manage in the event of your death – the named beneficiaries
receive the proceeds relatively quickly and it does not form part of your estate for the calculation of executor fees. You are,
however, able to contribute and withdraw from the fund just like for unit trusts. Life policies are often sold by financial advisors.
Life insurance policies are also usually protected against creditors in the case of your insolvency. A disadvantage is that
they usually incur higher fees than other forms of TFSAs.
Like unit trusts and other forms of savings, you can choose from a list of funds to serve as the underlying investment. These usually include a range of risk levels and asset class exposure.
The accounts can be bought directly from life insurance companies or through financial advisors. They are an ideal investment option if your ambition is to provide for the next generation.
5. Linked investment service providers (Lisps)
Lisps offer the easiest access to a wider universe of unit trust funds and the ability to easily trade between them. They are effectively an administration and product packaging service where consumers can buy and sell unit trusts as they wish through one service provider. They offer numerous funds and you can spread your investment between them or switch between them. They can therefore be a convenient way to
accumulate your tax-free savings, spread over multiple funds but with a single point to administer it.
Fees come at two levels – the Lisps’platform fees and the management fees charged by the underlying funds. Lisps are often able to negotiate down the fund fees which can compensate for the platform fees, though usually the overall
costs are slightly higher than investing directly in the underlying funds.
Not all Lisps offer tax-free investment products. In the directory in this guide we’ve listed only the ones that do.
Existing investments cannot be transferred into a tax-free savings account, even if they meet the parameters. The regulations state that contributions in respect of tax-free
investments must be an “amount in cash”, which would mean an individual would have to disinvest from an existing product and use the cash proceeds to contribute into the account.
Similarly, service providers are prohibited from converting a preexisting financial instrument or policy owned by an investor into a tax-free investment in respect of that investor. Investors are also prohibited from transferring portions of the value of their tax-free investments between service providers.
Products that expose investors to “an excessive level of market risk” are excluded. This effectively excludes investing directly in specific shares on the JSE – that is why ETFs are used. However, the ETFs themselves have to be registered as collective investment schemes to be eligible.
Other TFSA exclusions are structured products, smoothed bonus portfolios, investments with performance fees, investments with maturity terms longer than seven years and investments that charge high penalties for early withdrawals. Policies including life or disability assurance are also excluded.
Potential tax savings
The amount of tax savings you will receive depends on the type of account you choose. Existing tax exemptions mean traditional accounts are often also non-taxable. Specifically:
• An interest rate exemption on a cash investment of R23,800 (R34,500 if you are over 65)
• Capital gains tax exemption of R30,000
However, taxes such as dividend tax have no exemptions and can only be avoided through TFSAs.z
TFSAs become more tax efficient over the long term. For example, if you had invested R2,500 a month for the past 10 years on the stock market through a TFSA, your balance would be R828,220 at the end of the period if your returns mirror the JSE average returns, with total contributions of R300,000. The
capital gain would therefore be R528,200 which would result in a considerable tax saving.
It is also important to note that retirement savings vehicles such as retirement annuities can also offer significant tax advantages, largely because savings come out of pre-tax income. Individuals can direct up to 15% of their pre-tax income into a retirement annuity, which effectively means you are contributing up to 41%
more than you would from after-tax income (depending on your marginal tax rate).
However, retirement annuities come with restrictions on when you can access the savings and they are taxable when you do access them. Because of this, TFSAs work well as a top-up to
a retirement annuity. As a vehicle for long-term savings towards specific spending goals, however, TFSAs are ideal.