Maximise Your Tax Free Account to Save Thousands

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It doesn’t matter who you are or how much money you earn. You need to maximize your tax free account (TFSA) to save thousands. This is one investment that every single person must have. It should be the first investment that you open and the last one that you close.  Imagine how rich you would be if you paid no tax. Well, it is possible with a TFSA. Many countries have this including South Africa. Everybody benefits except the taxman

It sounds like it’s a savings account but it is not. Even though it’s called a tax-free savings account a better description is Tax-free investment account. You can think of it as a normal investment with a protective shield from tax. The savings account part is a bit misleading because it is not just savings. It could also contain other types of investment products. It is offered by most financial institutions, from banks to brokers

The TFSA was introduced in South Africa in 2015 to encourage savings. The main benefit is that you pay no tax on the growth of the investment. So you save paying the tax on interest, dividends and capital gains growth. All of this growth will continue to compound the value of the investment. The day that you decide to withdraw your investment you will be able to keep it all for yourself.

How does the TFSA work?

Firstly you need to open a dedicated tax-free account. Many financial service providers offer accounts like this including your bank, investment companies and stockbrokers. These institutions help to make sure that the account is used properly.

As an individual you can invest a maximum of R36000 per tax year, that is the period March to February. This money can be invested any way you want either as monthly contributions of R3000pm or as a lump sum or randomly. As long as you don’t invest more than R36000 between March and February of every tax year. These contributions can be stop-start and don’t need to be continuous.

There is a lifetime limit on this investment of R500 000. That means that once you have invested R500 000 you cannot add any more money to this account. If you invest R36 000 every year it will take you 13 years and 9 months to reach the R500 000 maximum. The maximum is calculated on your contributions not the total value of the investment

What can you invest in?

There are many options to invest in. As mentioned before it is not just an interest-bearing savings account. The option will depend on the financial institution that you choose but between them you can get almost anything. You can invest in cash savings, bonds, equities and property. These options are typically in ETFs or in funds and you can have a combination if you like.

So you could choose to invest in an equities ETF either local or international. This is very powerful because you are getting direct investment access to the stock market. The beauty of it is that all these returns that you make will be tax free and you maximise your tax free account to save thousands. If the equity market is too risky for you then you can choose some bonds or property funds to diversify.

How you should use it?

There are many opinions and bad advice out there about how to use the TFSA. If you think about it logically then you should realize that the longer you have the TFSA the bigger the benefit. This is because you gain the benefit of compounded interest, dividends and capital growth over time. So the best way to use it is to invest in the highest possible return assets for as long as possible.

The worst way to use a TFSA would be for some short-term savings goals. It is not a good idea to use it to save up for a car or a holiday. If you do this you lose all benefits of long term tax free compounding and a chance to maximise your tax free account to save thousands.

For me the perfect investment scenario is to open a TFSA account as soon as you can. Then you invest in an equities ETF of your choice and you get to the maximum contribution as fast as possible. Then you leave the investment until you are retired and you will have a huge investment that you can access tax-free.

What do the T&Cs say?

The lifetime limit of R500 000 applies to you as a person. You can have more than one tax-free savings account but you can’t exceed the annual or lifetime limit across all your accounts. If you do you will pay a 40% tax penalty.

If you withdraw money from the account you can’t add it back to get back to your limit. So once you have withdrawn an amount you will lose that part of your tax-free allocation.

There is a limit to the types of products that the institutions offer

Accounts can be moved from one FSP to another and you can have more than one account. You can buy and sell ETFs inside your account as long as you don’t withdraw from it.

How much can you save?

You can maximize your tax-free account to save hundreds of thousands. This is possible when you contribute the maximum and achieve a good investment return.

Lets look at an example of if you had invested from the inception of the TFSA in 2015 each year in an equity portfolio with a 10% annual growth

It will take you 15 years to reach the maximum R500k contribution

Due to the growth and compounding the value of your TFSA account will be over R 1 000 000.

How much tax can you save

If you chose a normal savings account then you would only save tax on the interest. Problem is that you already get a tax rebate on the interest of R23K. So assuming you don’t have any other interest-bearing investments you will not have a benefit from using the TFSA

However, if you invest with an equities portfolio then you could maximise your tax free account to save thousands

Let’s look at an example where you start to make TFSA contributions from age 25. You make the full contributions of R36K per year for 14 years and then you leave the investment for another 11 years before you withdraw. So that is a total investment period of 25 years and you are now 50 years old. Once again I assumed an annual return of 10% per year made up of 2% dividend payout and 8% capital growth. The graph below plots the two scenarios of TFSA vs Normal investment

You could save The TFSA value would be R 3.5M after 25 years and you would get all that money. However, had this investment been done normally you would have to pay dividends and Capital gains tax. This would cost you almost R900K in tax.

So just by using the TFSA you could save almost a million rand in tax

10 Tips to maximise your tax free account to save thousands

  1. Use your TFSA account as quickly as you can. You should prioritise this over most other investments and even debt payments if it makes sense. Contribute your full amount every year
  2. Go for the long term. The longer you invest in the TFSA the bigger the tax benefit. Its hardly worth it for investments of less than 5 years. Rather look at 15+year investments
  3. Flexible payments mean you can contribute what you can. Ideally as much as you can to make sure that you reach your R36K quota during the year. Even better go in with a lump sum at the beginning of each tax year. You can move money from you normal investment account into the TFSA as a lumpsum in March. This way you will get maximum dividends tax free for the year.  
  4. Don’t contribute too much then you will be penalised by paying 40% tax on the over contribution. This could wipe out your entire tax benefit if you are careless. Track your contributions diligently, a good service provider will help with this.
  5. Don’t ever withdraw out until the very end of the investment. You can but you reduce your lifetime limit so you will lose out on a lot of the tax benefits. This is a invest and forget investment, not a savings account.
  6. If you go long term then you can go with riskier assets like equities. You can also diversify into international equities. This sets you up for the biggest growth and biggest tax advantage. Going shorter period or more conservative saving type investment will give you very little advantage
  7. Go with a trusted a provider and don’t over pay on the fees. Consider different providers have different products with different fees.  Ideally you should be paying around 0.5% or less. Definitely not more than 1%. Every percentage point will eat into your profits and that ads up over many years.
  8. You can open a TFSA in your childs name and they could keep it for a long time and really benefit from the tax free growth. But problem is that you will be using up their lifetime tax free contribution allowance. It may be better for them to use it themselves.
  9. If you want to change providers you need to make arrangements to transfer the TFSA account between them. Don’t with draw from one provider and then open with another provider. You will use up your lifetime limits. Speak to the providers that will help to do the transfer so that you don’t lose your lifetime allowance.
  10. The TFSA needs to be looked after and managed. You also need to report it in your annual tax return. Make sure you do this right so that you don’t get nasty tax surprises later.

You can maximise your tax free account to save hundreds of thousands of rands during your lifetime. The sooner you start a TFSA account the better and the longer you keep it the better

I have opted for Easy Equities where I buy two ETFs, one is local and the other international. Just by signing up you get a TFSA account automatically.

You can check them out via my referral link here