Are tax-free savings accounts worth it?

It would benefit most South Africans to service their debts first

One will often hear and see mention of tax-efficient savings and investment products with each buildup to the end of the tax year. One such product is the tax-free savings account (TFSA). The TFSA refers to savings instruments where the capital growth and the return on the investment are not taxable. These savings instruments can take the form of a cash investment (think fixed deposit or notice account); unit trusts; equities; or a portfolio that is a combination of these instruments.

Tax-free savings accounts (and taxfree investments as a whole) were introduced by the national treasury on March 1 2015 to encourage saving in South Africans. Understanding the rationale for the introduction of this investment vehicle makes it easier to understand how rules governing how tax-free products work.

Annual and lifetime restrictions

TFSAs are available to all natural South African persons, regardless of age, and are limited to an annual contribution of R33 000 per tax year, and a R500 000 cumulative lifetime contribution. Although the total of an individual’s contributions into TFSAs cannot exceed R500 000, the total value of the investment is allowed to exceed this amount, as it is assumed that it will grow over time.

Allowance cannot be rolled over

Another mechanism government uses to increase the level and pace of savings in South Africa is by restricting the rolling over of the tax-free annual allowance. Annual contributions not utilised in a particular tax year cannot be rolled over into the following year and are thus forfeited, as the maximum contribution allowed in the following tax year remains the same.

Withdrawals cannot be reinvested

Making withdrawals from your TFSA affects your net contributions, as the withdrawal is not netted off against the annual allowance. For example, if you invest the maximum R33 000 into a TFSA, and then withdraw R10 000 in the same tax year, the net contribution will be R23 000, but the allowance utilised will be the full R33 000, and any further contributions will attract tax.

Switching products

Investors should consider carefully the appropriateness of their selected TFSA, as switching between TFSA products is currently not possible without it being viewed as a new contribution. If for example you have R10 000 invested in TFSA product “A” from prior years, and you would like to switch to TFSA product “B” offering higher returns, the process of switching will be treated as a disinvestment and reinvestment, i.e. the annual contribution for the current year will be reduced by R10 000 even though it was invested in a TFSA before.

Are tax-free accounts worth it?

TFSAs were introduced by the national treasury to encourage savings primarily among low- to middle-income earning South Africans. Government took this approach in response to the continuing financial vulnerability that South Africans within this income bracket were exposed to, not only as a result of low incomes and a high cost of living, but also due to a combination of high household debt levels and a low savings balance.

The expectation was that the tax exemption on the yield and capital growth on TFSAs would attract savings into these instruments – especially by those who were not habitually engaged in saving.

So, are tax-free accounts “worth it”? Well, the answer to that question depends firstly on who makes use of them, and secondly, if they are achieving the benefits for which these accounts were introduced.

Who are tax-free accounts best suited for?

On the face of it, TFSAs benefit every investor who chooses to utilise them, as the tax exemption is universal. However, the degree to which they benefit the investor is determined by the individual’s income level, investment mix, debt level and age.

Exploring each of these factors in turn will show that TFSAs may not actually be the most effective tool to encourage savings or reduce financial vulnerability for those who need it most.

TFSAs and your income level

TFSAs provide very little benefit to those individuals (under 65) whose total income falls below the tax threshold, currently R75 750. Using Cosatu’s widely accepted 2016 estimates, TFSAs are therefore of no value to around 60% of South Africa’s working population, as they earn less than R60 000 pa (per annum). An individual earning R60 000 pa would need to have just over R185 000 in an investment yielding 8,5% pa (net fees and commissions) before they would be liable for income tax — highly unlikely. And if by chance they did have such an investment, they could simply make use of the current interest tax exemption of R23 000 pa (individuals under 65) and avoid paying tax — all without the use of a tax-free savings instrument.

TFSAs and your investment mix

The investment product most often touted as the better alternative to a TFSA is the retirement annuity (RA). Many financial advisors argue that RAs make a better investment proposition as they have no lifetime contribution limit, whereas TFSA lifetime contributions are capped at R500 000, and the actual contributions into RAs are tax deductible (capped at R350 000) as opposed to TFSA contributions that are not.

Also, according to the treasury’s own statistics, only 6% of South Africans can afford to retire comfortably, meaning 94% will likely need financial support from government or family members in their retirement years. It thus follows that an investment instrument with both tax and retirement benefits is of greater benefit to the financially vulnerable.

TFSAs and your debt level

“You cannot save while you have debt” is a financial philosophy many people are familiar with, as they know that banks will always charge you higher interest on your debt than they will pay you on your savings. It is counterintuitive therefore to expect individuals that are currently indebted to direct their funds into savings as opposed to paying extra into their debt.

Even with a tax exemption on the interest income, making additional payments towards repaying debt provides a bigger net benefit to the individual for two reasons. Firstly, the interest saved on debt will be higher than the potential interest earned in the savings instrument (unless the instrument is unit trusts or equities) and secondly, the interest saved when making higher debt repayments is already exempt from tax.

Finally, with the average South African household spending R7 of every R10 earned on servicing debt according to a study by insurer 1Life, it is difficult to see why a TFSA that will provide benefits in the long term would be prioritised over settling debt, which will provide benefits in the short to medium term.

TFSA and your age

The younger you are, the more benefit you will derive from a TFSA because of the lifetime contribution limit. An individual who reaches their lifetime contribution limit of R500 000 at age 21 has many more years over which their investment can grow than an individual who does so much later in life. A high value TFSA will also provide much-needed greater flexibility at retirement age than an RA that comes with withdrawal restrictions, and taxation on the annuity income.

So, are tax-free savings accounts worth it? Yes, absolutely, if you are a young, high-income earning South African, with little to no debt, who is already making the maximum allowed contributions into their RA. I know few people who fit this profile, and those that do are certainly far from being considered financially vulnerable.