Keep your cash out of tax-free savings accounts
27 May 2015
Posted by: Author: Maya Fisher-French
Author: Maya Fisher-French (Fin24)
Investors are faced with a range of investment options when it comes to tax-free savings accounts (TFSAs). These include savings accounts with banks, unit trusts, certain share portfolios and exchange-traded funds.
But if you consider the current tax environment, it is only long-term investments in growth funds that would benefit from the tax-free savings structure.
Tax-free savings accounts come with a limit on how much you can invest. You can only invest R30 000 a year (R2 500 a month), with a lifetime limit of R500 000.
In comparison, there is already a tax exemption on interest income of up to R23 000 a year (R34 500 for people older than 65).
Assuming an interest rate of 5%, this means an individual younger than 65 could invest up to R460 000 today in an interest-bearing account and pay no tax on the interest earned – outside of the tax-free savings account. Individuals older than 65 could save R681 000 before they would start to pay tax on the interest.
Therefore, it makes little sense to waste the valuable tax-free savings opportunity on cash investments that already receive a tax benefit.
Another consideration is that cash investments tend to be short term in nature, so should only be used for savings goals of less than five years. You can never replace the money you withdraw from a TFSA because this counts against your lifetime limit.
For example, if over two years you had saved R60 000 in a TFSA and now wanted to draw on it for a deposit on your home, you would only have R440 000 left as part of your lifetime limit.
This would be a waste of the opportunity offered by TFSAs and, as you may not have even paid tax on the interest earned in a regular account, these short-term savings are better housed outside of a TFSA.
The real benefit of a TFSA is the long-term growth you receive by not paying dividend tax or capital gains tax over a period of time.
If you used your R30 000 each year, over 20 years this could boost your returns by about 36% as you would not have paid dividend tax during the period of the investment and would not owe capital gains when you came to sell the investment.
If, however, you are already fully using your existing tax exemption on interest income – which may be the case for a pensioner, for example – then the TFSA could offer you the opportunity to build up other tax-free cash funds. But it should not be an automatic investment decision.
This article first appeared on fin24.com.