With five tax year-ends since the launch of tax-free savings accounts (TFSAs) in South Africa in March 2015, many advisors and clients are still debating the best way to maximise the tax benefits of TFSAs. What has not helped much is that most product providers, including life companies, banks, unit trust management companies and LISP investment platforms, have jumped on the bandwagon and launched TFSAs over the past five years. This proliferation of TFSA product options, with the accompanying wave of good-news marketing material, has left many investors and advisors wondering how best to utilise a TFSA as one of a number of tax-efficient savings tools.
In this article we will share some of the feedback we have received when discussing this problem with financial advisors, and highlight the implications of some of the different options available to investors.
1. A TFSA is not the only available tax-efficient savings option
The media hype about TFSAs appears to have taken people’s eyes off the fact that the first savings priority for any investor should still be their contribution to a registered retirement fund (either through their employer or via a retirement annuity). As a rule of thumb, investors should first provide for an adequate contribution to their retirement fund before taking out a TFSA. The potential compounded tax saving from a client’s contributions to a retirement fund early on in their career dwarfs the tax benefits on a TFSA.
Secondly, investors should remember to use their annual tax-free interest exemption (currently R23 800 for individuals under age 65 and R34 500 for people aged 65 and older). At current money market rates of just over 7%, and various other income funds offering close on 9% p.a., an investor in South Africa can keep approximately R300 000 in a fixed income fund before paying any tax on the interest earned. Ideally, this allowance should be used to set up an investor’s emergency cash pool.
Advisor takeaway: Make sure the investor has a sound retirement plan and emergency cash reserve in place before channelling money to a TFSA.
2. The tax benefits of TFSAs compound exponentially with time
When TFSAs were originally launched, many investors and advisors underestimated the extent to which the tax benefits on TFSAs need time to compound. You need time to realise the tax benefits on these investments because a TFSA contribution is not tax-deductible upfront like a retirement fund contribution. This simple difference makes it remarkably difficult to calculate upfront the rand value of an investor’s tax benefit.
In addition, the lifetime TFSA contribution limit further delays the real tax benefit to the time when the investor has used their full lifetime contribution allowance.
These points are best illustrated by an example. In Figure 1 we project a TFSA’s fund values over a twenty-year period, based on the following assumptions:
- An investor contributes the maximum annual amount of R33 000 and this limit is never increased by Treasury.
- The R500 000 lifetime limit is never increased, and contributions cease when this limit is reached.
- Assume a 10% p.a. investment return and inflation of 6% p.a.
- Further assume a roughly 50/50 split in investment return between interest and capital gain, resulting in an effective combined tax rate of 30% on total investment returns.
Figure 1: TFSA value projection split between contributions and investment return
From the diagram there are three points to note:
|1||The investment return (the blue bars) and the tax saving (pink line) take a long time to accumulate and only really become meaningful after about ten years.|
In the first five years the value of the tax benefit is incredibly small.
|3||Yet after twenty years the tax saving represents over 20% of the total fund value.|
From a tax benefit perspective, it appears to not make sense for an investor to utilise a TFSA for an investment horizon shorter than ten years. This picture changes dramatically though after ten years due to the well-known compounding effect of long-term investment returns.
Advisor takeaway: TFSAs need to run for a minimum of ten years – otherwise the tax benefits are wasted.
3. Lifetime TFSA contribution limits are precious – don’t waste them
Current TFSA product rules, as set out by Treasury, do not allow an investor to recover any part of the lifetime TFSA contribution limit should they need to dip into the TFSA assets to fund an emergency expense. Every time an investor uses part of their TFSA contribution allowance, that allowance is gone forever.
Any redemptions from a TFSA therefore waste part of an investor’s lifetime contribution allowance – ideally something to be avoided.
Advisor takeaway: TFSA lifetime credits are very valuable – discourage investors from wasting their credits by dipping into their TFSA’s assets over the course of the investment term.
4. Investment portfolios should be consistent with investment horizon
A final point for discussion is what represents the ideal investment portfolio for a TFSA. There really should be two key considerations when deciding on an appropriate investment portfolio:
- As highlighted above, TFSA investments should be for ten years or longer, and portfolios should reflect this reality.
- Since TFSAs do not attract income tax or capital gains tax, the risk/return characteristics of TFSA portfolios are neutral to whether returns come from capital gain, interest or dividends.
One way to simplify this problem is to evaluate different investment strategies with reference to a long-term return and volatility measure, and see how they stack up. In Figure 2 we do exactly that, highlighting the fifteen-year annualised returns and volatility statistics for a number of potential TFSA investment options:
Figure 2: Fifteen-year annualised return/volatility for a number of TFSA investment options to 31 December 2019
Source: Morningstar Direct, as at 31.12.19. Performance figures are based on a lump sum investment, NAV to NAV, net of fees. Highest and lowest annualised returns since inception of the Investec Opportunity, Investec Equity and Investec STeFI Plus funds (12-month rolling performance figures) are: 43.8% (31.07.05) and -15.7% (28.02.09); 65.8% (30.04.06) and -34.8% (28.02.09); 13.8% (30.06.01) and 4.2% (31.08.14), respectively. The total expense ratio of the Investec Opportunity, Investec Equity and Investec STeFI Plus funds (A class) are: 1.31%, 1.19% and 0.70%, respectively. Funds shown are for illustrative purposes only and are not necessarily the classes available on the IMS TFSA platform.
Figure 2 illustrates what most of us already know intuitively – more conservative portfolio choices merely reduce the likely long-term investment returns without really adding anything. Fixed income investments can appear attractive as they attempt to maximise the value of the tax saving (the logic being that interest is taxed at a higher effective rate than capital gains). However, this logic is flawed – it is not only the value of the tax saving that matters – it is the sum of the tax saving and the investment return achieved. As can be seen in Figure 2, fixed income investments tend to disappoint in terms of their total long-term investment returns.
It seems that a good starting point for most TFSA investors is to consider South African unit trust funds from the “ASISA Domestic Multi-Asset: High Equity” or similar category. These funds have historically produced very attractive long-term risk/return trade-offs, and work even better when tax does not affect the structure of the investment decision. One can comfortably move even higher up the risk curve, especially for longer investment horizons. The most commonly selected investment option for the Investec IMS TFSA, for example, has been the Investec Global Franchise Feeder Fund.
Advisor takeaway: TFSAs are long-term investments and should therefore have investment portfolios structured to maximise long-term investment returns. Cash and fixed income are poor long-term investments.
TFSAs are a great initiative from government to encourage savings in South Africa, and they are important tools for a financial advisor. However, it is important to set them up correctly as long-term investments in order to maximise the value of the client’s lifetime tax benefit.