Can a tax-free savings account help you retire early? Building a long-term plan

Financial independence and retiring early are the ultimate goals for many people, and understanding the benefits of a tax-free savings account (TFSA) can be a major step on your way towards a comfortable retirement. In South Africa, early retirement may generally be considered retiring before the age of 60, but the earliest allowable withdrawal age for retirement investment products is 55.  

To retire early, starting your retirement plan while you’re still young and working is an absolute must. A tax-free savings account is a long-term investment savings vehicle that is often overlooked as part of a long-term financial plan, but can be incredibly beneficial and effective in getting you towards your overall retirement goals.   

An introduction to investments in South Africa [video] - Rands and Sense by 10X

Want to know about offshore investing, property as an asset class, tax-free savings accounts and everything in between? Rands and Sense by 10X is here to help you understand investment fundamentals. Read more

10X has a record of lower costs and superior returns, allowing you to retain tax advantages and grow your savings while maintaining full control. In this article, we’ll discuss whether a TFSA can help you retire early. We will delve deeper into the benefits, limits and how to plan your TFSA to optimise its features. 

What is a tax-free savings account, and how does it work? 

A tax-free savings account is a long-term savings investment vehicle, implemented in South Africa in 2015 as a means to encourage South Africans to save more money. A TFSA isn’t a savings account in the traditional sense; it is actually an investment product. If you decide to start a TFSA, you need to be aware of the various limits associated with the investment vehicle.  

The maximum amount that you may contribute to a TFSA is R36,000 per annum (R3,000 per month) and R500,000 over a lifetime. It’s important not to exceed these contribution limits, as this will result in a penalty of 40% being imposed on the excess contribution. Keep in mind that you are not taxed on any of the growth within your TFSA.  

In other words, there is no dividend, interest or capital gains tax. This allows for more of your returns to be reinvested and potentially grow and compound over time. A TFSA is a long-term investment, so if possible, it is best to leave the money invested and avoid short- and medium-term withdrawals. When you do withdraw, these withdrawals are not taxed, and there are no penalties imposed for withdrawing. This is the power of the TFSA – left to compound for long enough, you can withdraw significant amounts of money tax-free. 

A tax-free savings account is a straightforward, but powerful savings tool that is designed to reward discipline over time. As long as you stick to the contribution limits and allow your savings to grow, you can get the most out of a TFSA. All in all, a TFSA gives you a flexible and tax-efficient investment to use in retirement.  

Why TFSAs are attractive for early retirement  

For those seeking early retirement, there are plenty of advantages offered by TFSAs. Here are a few of the main reasons that TFSAs stand out as a smart option for early retirement planning: 

First and foremost, and perhaps the biggest advantage, is the fact that all withdrawals are completely tax-free. As such, this makes it an ideal income source for those planning to retire early. Unlike with other savings and investment vehicles, there is no penalty for accessing your savings early.  

TFSAs are not bound by the same access restrictions as retirement annuities. Anyone who needs to access the money before retirement age can do so without issue. Your TFSA will offer immediate liquidity with no red tape, so you can manage your financial needs on your own terms. This flexibility in terms of accessing your savings is a major advantage for investors.   

As you do not need to pay tax on the growth within your TFSA, you can take better advantage of the potential compound growth. You have more of your returns available to be reinvested and allowed to potentially compound and grow over the long term.  

When we look at the above together, we can see how tax-free savings accounts can be a valuable part of an early retirement strategy. The flexibility, tax efficiency and growth potential all give early retirees more control over finances, and some peace of mind, knowing it can be accessed when needed.  

A TFSA can provide you with security and freedom on your way to financial independence, alongside other retirement vehicles. As this is a long-term plan, allowing your TFSA to grow and potentially compound over time is a key part of retirement planning. Let’s look at the power of compound growth in more detail.  

The power of compound growth in a tax-free environment  

Compound growth is an important factor in the growth of your TFSA over time. This starts off slowly and accelerates as your TFSA grows, highlighting the importance of opening your TFSA early. By not needing to pay any tax on the growth of your TFSA, you are able to really boost the growth of your TFSA, especially over the long term. 

So, how exactly does compound growth work? Let’s look at an example to get a clearer picture.  

For the sake of the example, let’s assume you invest R3000 per month into a tax-free savings account over 40 years, with a consistent annual return of 6% after inflation, compounded monthly. As TFSAs are capped at R500,000, after 13 years and 11 months, you can no longer make any additional contributions.  

Fortunately, your investment will continue to grow untouched for the rest of the 40-year period. After 40 years, your final balance is equal to R3,517,235.11 in today;s money (if we were not accounting for inflation, the total would be much higher). This highlights the power of compound growth. As this is a TFSA, you can withdraw the full amount without needing to pay tax. This example is for illustrative purposes only, and real results may vary.  

Structuring your asset allocation effectively  

As an investor with 10X, you can choose from a selection of carefully curated investment funds with different asset allocations, geared towards different investor profiles. Since you’re hoping to retire early, getting the asset allocation in your TFSA right is key. Asset allocation refers to the mix of different assets in which your savings are invested. These will usually be a mix of equities, bonds, real estate (property) and cash.  

Equities typically produce good returns over the long term, although they are also the most volatile of the asset classes. Despite the volatility, they may realise the highest returns in the longer term.  Equities have historically produced returns above inflation by around 7% annually over the long term (based on JSE All Share Index performance versus CPI from 1960-2020); however, past performance does not guarantee future results.  

Bonds and cash both add stability to a portfolio, although they are likely to generate lower returns than equities. Cash will likely produce the lowest returns of all the asset classes. You should select your asset allocation according to your investor profile, looking at factors such as your risk tolerance levels and the time horizons that you have.  

A more risk-tolerant investor may wish to include more equities in their portfolio compared to a more risk-averse investor who may prefer to include fewer equities, and more bonds and cash for stability. Diversifying across the asset classes allows for gains in certain asset classes to be realised while also mitigating against losses in other asset classes. Including offshore exposure in your portfolio allows you to take advantage of potential gains in the offshore market while mitigating against any local market volatility which may occur and subsequent depreciation of the Rand.  

10X offers a wide range of funds within the TFSA wrapper, all suited to different investor profiles. As such, there is sure to be a fund to suit your risk tolerance and investor profile requirements. 10X also offers the option to invest your TFSA 100% offshore.  

10X TFSA Funds  

Different funds are tailored to various investor profiles. Here are a few of the options that you have available at 10X. 

10X Your Future Fund: The 10X Your Future fund is designed to deliver cost-effective exposure to a range of local and international asset classes. The fund has a higher allocation to growth assets, such as equities and property, and is well-suited for investors seeking long-term capital appreciation to build wealth. The portfolio offers diversified exposure across multiple asset classes and geographies. Fund exposure is set at 63.2% local and 36.8% offshore.  

10X MSCI World Index Feeder Fund: The 10X MSCI World Index Feeder Fund tracks the MSCI World Index to provide investors with comprehensive offshore exposure, capturing the performance of large and mid-cap equity securities across 23 developed market countries. The fund aims to closely match the dollar-based iShares Developed World Index Fund (UCITS) in ZAR. The fund gives investors 100% offshore exposure and a diversified portfolio across 23 developed market countries.    

10X Moderate Fund: The 10X Moderate Fund is best for investors who want capital growth with a lower level of volatility than a high equity portfolio over the medium to long-term, achieved via cost-effective exposure to a range of local and international asset classes. The portfolio has a greater allocation to growth assets, such as shares and property, than to defensive assets like bonds and cash. The recommended time horizon is 3 years or longer. The fund exposure is set at 66.2% local and 33.8% offshore.   

10X Defensive Fund: The 10X Defensive Fund is best for investors who want a steady level of income alongside capital growth at low volatility over the medium term, achieved via cost-effective exposure to a range of local and international asset classes. The portfolio has a greater allocation to defensive assets, such as bonds and cash, than to growth assets like shares and property. The recommended time horizon is 1-3 years and longer, as returns may be volatile in shorter periods. Fund exposure is set at 73.5% local and 26.5% offshore.  

These are just a few of the available funds at 10X. You can learn more about what’s on offer here.  

Building a long-term TFSA strategy 

To create a successful long-term TFSA strategy, discipline and careful planning are key. Here are a few key tips to help you get the most out of your TFSA:  

Start Early, Stay Consistent: You should start contributing to your TFSA as early as possible, ideally in your 20s or 30s, to take full advantage of compound growth over time. You also want to ensure that you don’t exceed the contribution limits set on the TFSA to avoid penalties and maintain the account’s tax-free status.  

Prioritise Growth Assets: Consider allocating a portion of your TFSA to growth assets, such as equities, to get the most out of your long-term returns. A well-diversified portfolio that is focused on capital appreciation may potentially enhance the value of your TFSA in the long term.  

Be Cautious About Withdrawals: A TFSA should be seen as a long-term investment savings vehicle, and you should avoid withdrawals if possible. If you do withdraw, it’s important to remember that these withdrawals cannot be added back in again, as they have already counted as a contribution.  

Use TFSA as Part of a Broader Retirement Plan: A TFSA can be a very useful part of your retirement plan, especially when integrated into a broader retirement strategy. You can use your TFSA account alongside other vehicles, such as retirement annuities or preservation funds. The tax-free savings account gives you both flexibility and tax efficiency, and in combination with other vehicles, can help you build a well-rounded and resilient retirement portfolio.  

With these tips and strategies, you can turn your TFSA into a hugely beneficial tool for long-term wealth building and retirement planning.  

Managing Your TFSA and EAC 

Another important factor that impacts the long-term growth of your TFSA is the fees you are obligated to pay. If more of your returns are being used to pay for higher fees, this may mean that there are fewer returns available to be reinvested and allowed to potentially grow over time. On the other hand, if you are paying lower fees, this may mean that there are more fees available to be reinvested and allowed to potentially compound and grow over the long term.  

The Effective Annual Cost (EAC) of your investment refers to the total costs and fees involved with owning an investment over a one-year period of time. It is a standardised metric which was introduced by ASISA in 2015. The EAC is expressed as a percentage, and it allows you to see the costs and charges associated with your TFSA. You can then compare this information with that of other service providers to make an informed decision. You will usually find your EAC displayed on your investment statement. If this is not the case, you may request your EAC from your service provider. The typical fees that you may see charged on your TFSA are: 

Administration fees: These are the fees which are charged for administrative tasks. This would be for tasks related to tax, compliance, reporting and similar. 

Advisor fees: These are the fees charged by advisors for their advice and services. This may be an initial and an ongoing fee. 

Management fees: These are the fees charged for the management of the fund. 

Other fees: Certain products may have other applicable fees charged, such as early exit penalties. 

All things being equal, a lower EAC means that more returns are available to be reinvested with the potential to grow and compound over time. A higher EAC may mean that there are fewer returns available to grow and benefit from compound growth over the long term. The EAC of an investment would be just one factor to consider when comparing and evaluating service providers. You can learn more about how fees impact investment growth here.  

At 10X, fees are kept simple and transparent, making it easy for all investors to understand. We offer low fees of less than 1% for most products, depending on the product and the amount invested. To find out our most up-to-date fee information, please visit our website or speak to our experienced and knowledgeable investment consultants who are always happy to take your call.  

Limitations of TFSAs for early retirement  

While we can see how TFSAs can be beneficial for retirement planning, there are a few limitations to keep in mind.  

Firstly, the cap on contributions means that you may not be able to invest as much as you would like in this particular vehicle, hence the importance of using a TFSA alongside other retirement vehicles. Using a TFSA in isolation for retirement will likely not provide you with enough income to last for your retirement years.   

As discussed above, if you do withdraw from your TFSA, you are unable to add these contributions back in again as you have already used this ‘contribution room’. Once you have reached the cap, you can no longer add any more of your savings.  

Finally, as the TFSA is easily accessible with no penalties on withdrawals, it means that you will need to be disciplined in order to avoid making unnecessary withdrawals. Withdrawals will impact the long-term growth of your capital, as they reduce the amount of capital available to grow and potentially compound over time.  

Even with these limitations, the tax-free savings account remains a valuable tool for building long-term and tax-free wealth. When you know its limitations and use it strategically, particularly alongside other retirement products, you can take full advantage of its benefits.  

Final Thoughts: Building wealth with a tax-free savings account 

In conclusion, TFSAs are an excellent part of a long-term financial plan. Along with their tax benefits, they can play an important role if you are considering an early retirement. They may also be a useful source of income before you formally retire, which is allowed from age 55 in South Africa.  

You want to make sure that you contribute regularly, avoid early withdrawals, select an appropriate asset allocation and keep an eye on the fees that you are paying. Overall, a TFSA can be an effective and efficient means of saving capital over the long term and an integral part of your financial plan. While a tax-free savings account alone may not be enough for your retirement needs, when used alongside other vehicles, it can be incredibly beneficial.  

If you have any questions regarding setting up a new TFSA, please contact our excellent investment consultants at 10X for more information. Get in touch today and grow your savings with a 10X tax-free savings account!