Risk tolerance and asset allocation in tax-free savings accounts

The uncomfortable truth about retirement in South Africa - Rands and Sense by 10X [video]

We sit down with 10X Investment Consultant lead Andre Tuck and discuss the retirement savings crisis in South Africa. We also delve into living annuities, retirement annuities, TFSAs and everything in between. Read more

Since its introduction in 2015, tax-free savings accounts have become a valuable tool for building long-term wealth. TSFAs are designed to encourage South Africans to save, offering appealing tax advantages that can enhance growth over time.   

The success of your tax-free savings account doesn’t just depend on the tax benefits, however, as asset allocation plays a key role. Choosing an asset mix that matches your risk tolerance and investment profile is a major part of achieving your long-term financial goals with confidence. In this article, we’ll discuss risk tolerance and the role of asset allocation in tax-free savings accounts. 

What is a tax-free savings account? 

A tax-free savings account is not a savings account in the traditional sense. TSFAs are actually investment accounts with greater potential for strong capital growth over the long term. We often see South Africans treat tax-free savings accounts like fixed deposits, but this can be detrimental to their savings.   

Investors benefit from several tax advantages when it comes to tax-free savings accounts, and the growth potential is greater than that of a regular savings account. In general, a tax-free savings account should be viewed as a long-term investment vehicle, rather than a savings account that you can regularly withdraw from.  

There are certain limits that must be adhered to when it comes to a tax-free savings account. You are allowed to contribute a maximum of R36,000 per annum (R3,000 per month) and a maximum of R500,000 in a lifetime. If you exceed these limits, a penalty of 40% is charged on the excess amount.   

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

There is no tax on any growth that takes place within a tax-free savings account. As such, you don’t have to pay tax on interest, dividends or capital gains. Returns can instead be reinvested and potentially grow and compound over time. Additionally, there is no tax charged on withdrawals, but it’s important to remember that once you have withdrawn capital, you can’t add this back into your tax-free savings account. Most financial experts recommend avoiding withdrawals from your tax-free savings account to take full advantage of compound growth.  

Understanding risk tolerance in a tax-free savings account 

Your risk tolerance refers to your appetite for risk. In other words, how comfortable you are with short-term market volatility and the potential loss in value of your tax-free savings account at certain times.   The market moves through cycles, and while downturns can lead to short-term losses, when the market bounces back, these losses will be regained, and the tax-free savings account will potentially continue to grow and compound over time.   There are generally three kinds of risk profiles.   

• Conservative: You prefer stability and predictability, aiming to minimise risk even if it means accepting potential lower returns.  
• Moderate: You’re comfortable taking on some risk to achieve a balance between safety and growth.  
• Aggressive: You’re willing to accept higher levels of risk and short-term volatility in pursuit of stronger long-term returns.  

There are a variety of factors that can shape your risk tolerance levels. These include factors such as your age, investment timelines, your financial goals, your financial security and your levels of financial literacy and experience. Your risk tolerance levels could also include factors like your personality or temperament (some people are naturally more comfortable with taking risks than others), as well as your personal past experiences that you’ve had when it comes to investing. 

Retirement Annuity vs Tax-free Savings Account vs Bond: Where Should Your Extra Money Go?

Got extra money to invest? Compare three powerful options: Retirement Annuity, Tax-Free Savings Account (TFSA), or paying off your bond faster. Learn the pros and cons of each to make an informed choice for your financial future. Read more

The importance of asset allocation in TFSAs  

Before we dive any further into the importance of risk tolerance, let’s first review asset allocation. As an investor with 10X, you can customise your underlying portfolio by choosing from a selection of carefully curated funds to invest in; each fund has a different mix of assets and is geared towards different investor profiles. These funds enable you to diversify across various asset classes such as equities, property, bonds, and even offshore investments.  

Equities are most likely to generate the best returns in the long term, although they are also generally the most volatile of the asset classes. As data suggests, 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), but past performance does not guarantee future results.   

Bonds tend to be less volatile and can add some stability to your portfolio. Real estate, on the other hand, offers potential for strong returns but can also experience periods of volatility. Cash is the most stable of the asset classes, but often produces the lowest returns.   

Diversification across the asset classes allows you to balance both risk and growth. You can spread your risk, protecting your portfolio from significant losses during market downturns while allowing you to benefit from growth opportunities elsewhere. You may also want to consider offshore investments, as diversifying internationally can give you access to a broader range of industries and companies, while also serving as a hedge against local economic or political uncertainty and the potential depreciation of the rand.  

We've built the 'happy retirement' machine

Understanding the most effective strategy for investing your retirement savings is fundamental to experiencing a happy retirement. We've built an investment machine that gives you a great chance of really golden years. Read more

10X offers a wide range of carefully selected funds which are well-diversified across the asset classes. You can select the fund or funds that match your investor profile within the TFSA wrapper. You can view our TFSA fund options here. 

Why risk tolerance matters in a TFSA  

It’s essential that you seek to match your risk tolerance levels with your asset allocation with the view to maximising the potential growth of your TFSA, while balancing your risk. Let’s look at a few examples to help illustrate this concept.   

If you choose an asset allocation that is very conservative, i.e. invested heavily in cash, and this doesn’t match with your risk tolerance levels, there is the potential for a loss in returns compared to what may otherwise have been realised with a more well-aligned asset allocation.   

By including equities in your portfolio, aligned with your risk profile, you are potentially able to generate greater returns, which can then potentially snowball, allowing you to realise the compounding advantage. Conversely, if you select an aggressive portfolio, which is not aligned with your risk tolerance levels, you run the risk of knee-jerk decisions and panic selling in response to a downturn in the market. 

A vampire wouldn’t drain you as much as some investment managers

This Halloween, Nicola Mawson is finally burying those unnecessary investment fees for good. Read more

As previously mentioned, you don’t pay any tax on the returns generated within your TFSA. In other words, you will not pay income tax, capital gains tax or dividends tax. This means that there are more returns available to be reinvested and allowed to potentially grow and compound over time, further boosting the potential advantages of compound growth. For this reason, you want to ideally keep your funds invested and avoid withdrawals as far as possible. There are no limits on withdrawals, and you will also not pay tax on withdrawals, but keep in mind that once a withdrawal is made, you cannot add it back again, as you’ve already used up this portion of your contribution limits.  

Linking Risk Tolerance to Asset Allocation  

Your asset allocation should reflect both your risk tolerance and investment horizon. Generally, this means balancing how much market volatility you can comfortably withstand against how long you plan to stay invested. At 10X, we believe in matching your mix of assets to your personal goals, rather than trying to time the market.  

A conservative investor, typically focused on preserving capital, may hold around 30% equities, 60% bonds and 10% cash, providing stability with some modest growth potential. A balanced investor with a medium-term horizon could opt for roughly 50% equities, 35% bonds and 15% cash, blending growth and income while limiting volatility. An aggressive investor with a long-term outlook, on the other hand, may look to allocate 80 to 90% to equities and 10-20% to bonds or cash, with a greater focus on higher-growth assets.  

Diversifying across asset classes, and even offshore, helps smooth returns and protect against local economic or currency shocks.  

Fee Considerations 

Fees can play a major role in the potential growth of your tax-free savings account. You would ideally look to minimise fees as far as possible, as high fees may result in lower returns available to be reinvested and allowed to potentially compound over the long term. Low fees may mean that there are more returns to potentially reinvest and compound over time.  

The typical fees that you may see charged on your TFSA are the following: 

Administration fees: These are the fees charged for administration-related tasks. These will be for tasks such as tax and compliance. 

Advisor fees: Advisors will charge fees for their services. There will typically be both an initial and an ongoing fee charged.  

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

Other: There may be other costs deducted which are applicable to certain products.  

Let’s look at an example to compare fees of 1% to fees of 3%. We will assume the following information:   

• Monthly contribution amount: R3,000  
• TFSA lifetime cap: R500,000 (reached in just under 14 years)   
• Investment term: 30 years  
• Annual return: 12%  
• Annual inflation: 6%   
• Contributions will stop after reaching the cap in 13 years and 11 months, but the money stays invested for 30 years.  

Scenario 1 (1% in fees): After 30 years, final investment value is approximately R1,438,627  

Scenario 2 (3% in fees): After 30 years, final investment value is approximately R901,248  

Want to see what you could get out? Try our TFSA calculator and do your own sums. 

As you can see, a difference of 2% can result in a significant difference in the final investment value, especially when this is compounded over a time period of 30 years. The importance of minimising fees is very evident. This example is for illustrative purposes only, and actual results may vary. You can learn more about fees here.  

The Effective Annual Cost (EAC) is the total fees and costs that come with owning an investment over a one-year period of time. This is a measure first introduced by ASISA in 2015. All factors being equal, you may find that a higher EAC means that there are fewer returns to be reinvested and allowed to compound over time. A lower EAC, on the other hand, may mean that there are more returns available to be reinvested and allowed to compound over the long term. When comparing service providers, the EAC of your investment would be just one factor to consider when evaluating.  This useful calculator, offered by 10X as a part of our free online suite of tools, allows you to compare the EAC charged by 10X with the EAC charged by your current service provider. You can then use this information to evaluate your options.   

At 10X, we look to minimise fees whilst aiming for superior returns for our clients over the long term. Due to our index tracking investment strategy, we can charge low fees of 1% or less for most of our retirement products. You can learn more about our investment strategy here.

Practical Steps to Find Your Fit 

Understanding your risk tolerance starts with honest self-reflection. Asking yourself a few key questions can help you determine where you sit on the risk spectrum.   

• How do you react to market downturns? Would you feel panicked if there was a sudden market crash, or would you feel comfortable riding it out? 
• What’s your investment horizon? Are you planning to keep your TFSA invested for a few years or several decades? Is there a chance you may need to withdraw in case of an emergency?   
• How involved are you with investments? Do you regularly check your investments to see how they are doing? Or are you satisfied with leaving your TFSA and letting the market do its work? 
• How comfortable are you with uncertainty? Do fluctuating returns make you uneasy, or do you view them as part of a long-term growth journey?  

These questions can help you self-assess your risk-tolerance levels. You can also get in touch with our experienced investment consultants at 10X for any additional queries you may have.  Final thoughts on tax-free savings accounts and risk tolerance Your TFSA is a powerful investment vehicle that allows you to potentially grow and compound without needing to pay tax on your returns. In general, you’ll want to select a fund with an asset allocation that meets your investor profile and risk tolerance levels. Keeping your savings invested over the long term and avoiding withdrawals should be highly prioritised.  

10X offers a transparent and well-diversified TFSA option. Our track record of low cost and high returns allows you to retain tax advantages and grow your savings while maintaining full control. Get in touch today to get started or to learn more!