Why a tax-free savings account is not just a “savings” account – and what that means for your wealth

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A tax-free savings account is not a savings account in the traditional sense; it is actually an investment account with the potential for excellent capital growth over the long term. Often, South Africans treat the tax-free savings account (TFSA) like a fixed deposit, when this is actually detrimental to their savings.  

A tax-free savings account offers several tax advantages, and when managed correctly, the growth potential is much higher than that of a regular savings account. As such, the TFSA should be viewed as a long-term investment vehicle rather than a savings account that can be regularly dipped into. In this article, we will break down what a tax-free savings account really is and how you can maximise the potential compound growth within it.   

What is a tax-free savings account (TFSA)?  

A TFSA is a long-term savings and investment vehicle implemented by the National Treasury in 2015. The tax-free savings account was introduced as a method of incentivising South Africans to invest more and accumulate savings.  

There are, however, certain limits to be aware of when it comes to a TFSA. You can contribute a maximum of R36,000 per annum and a maximum of R500,000 in a lifetime. Once you’ve reached this cap, you can no longer make any contributions. Additionally, you should avoid exceeding these limits, as doing so will result in a penalty of 40% on the excess amount.  

There is no tax on any growth within the TFSA, so you will not need to pay tax on interest, dividends or capital gains tax. This generally allows for more returns to be reinvested and potentially grow and compound over the long term. There is also no tax charged on withdrawals, but keep in mind that once you have withdrawn capital, you cannot add this back into your TFSA, and the opportunity for potential growth is missed. As such, financial experts generally recommend avoiding withdrawals to take full advantage of compound growth.  

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Why some people misuse their tax-free savings accounts  

Due to the name, some investors make the mistake of viewing a TFSA as more of a short-term savings account, rather than a long-term investment vehicle. This can result in people choosing to invest the capital in a low-yielding cash fund, which may then result in poor growth of the capital, with the capital struggling to beat inflation.  

Another common mistake is withdrawing too early. As withdrawals are tax-free, people often see the TFSA as an emergency fund with easy access. But withdrawing money results in some contribution space being permanently lost. As such, the long-term compounding benefit of the account is reduced, and the investor is worse off than if they had avoided withdrawals.  

Some investors also make the mistake of over-contributing. This may be unintentional or due to a failure to understand the contribution limits. This can lead to a tax penalty of 40%, which undermines the whole purpose behind having a tax-free savings account in the first place. 

Additionally, investors sometimes fail to grasp the role that a tax-free savings account should play in a financial plan. Some may spread contributions across multiple providers without keeping track, under the assumption that it works like a retirement annuity with additional tax deductions. In truth, the value of a tax-free savings account lies in the ability to withdraw capital tax-free after it has grown (hopefully!) for decades. 

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Why tax-free savings accounts are built for long-term growth 

TFSAs can be a powerful investment vehicle, allowing more returns to be reinvested due to the tax advantages on offer. This also means there is more opportunity for compound growth, especially over the long term. You may consider using your TFSA to save for retirement or just as a general means of accumulating savings. Upon your passing, your TFSA forms part of your estate and can be transferred to your heirs, but it won’t retain its tax-free status for them.  

Regardless of your end goals, a TFSA has the potential to perform best when the capital remains invested over the long term, as this allows for compound growth to really have an impact on the tax-free returns that may be generated. Let’s take a closer look at the potential benefits of compound growth with an example:  For the purpose of the example, let’s say you invest the maximum R3,000 per month into a TFSA over 40 years and achieve an average annual return of 6% after inflation, compounded monthly. After 13 years and 11 months, you will have invested the maximum R500,000 and can no longer make contributions.   

Your investment will continue to grow untouched for the rest of the 40 years, even though you can no longer make contributions. At a 6% average annual return, compounded monthly, your final balance would be equal to around R3,517,235 (remember that this amount is adjusted for inflation – without that, it would likely be much higher, and indeed, many TFSA calculators out there show you those massive-looking figures. Don’t be fooled, goods and services will cost more in the future, and the value of your money will go down). And the best part? You can withdraw the full amount, completely tax-free.  

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We can clearly see the benefits of staying patient and allowing your capital to potentially compound over time in a tax-free savings account. Note that this example is for illustrative purposes only, and real results may vary. H2: How to use a TFSA like an investment account We can see how, to maximise the potential of the TFSA, you would want to treat it as a long-term investment account. Let’s look at a few ways in which you can do this:  

• Look to invest your money in growth-oriented funds that include equities. Balanced funds that include equities often deliver higher long-term returns compared to cash investments.  
• Avoid withdrawing from your accumulated savings, as these contributions cannot be added back in again. Remember, every withdrawal reduces your contribution room forever.  
• Don’t be put off by market volatility that may occur in the short term; look to the long-term and focus on your long-term strategy. Markets will rise and fall, but history shows that patient investors are often rewarded over time.  
• Take a disciplined and consistent approach to investing: set up a monthly debit order so you don’t need to manually put through additional capital. Automating contributions means you won’t have to be as reliant on self-discipline to get the advantages of consistent contributions. Lastly, pay yourself (i.e. invest in your TFSA) at the beginning of the month. This is key.  

The role of low fees in unlocking growth  

Some investors also fail to realise the major impact that fees can play in the potential growth of their tax-free savings account. The importance of staying aware of all fees should not be overlooked.  You should, therefore, always review the Effective Annual Cost (EAC) of your investment. This is a standardised metric which was introduced by ASISA in 2015. It refers to the total fees and costs of owning an investment, such as a TFSA, over one year.  

All factors being equal, a higher EAC may mean that there are fewer returns available to be reinvested and potentially contribute to the growth of your TFSA. A lower EAC might result in greater returns available to potentially compound over the long term. This would be just one factor to consider when comparing service providers.  

The usual fees that you can expect to see charged on your TFSA are as follows: 

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

Advisor fees: An advisor will charge fees for the services and the advice that they give you. There is typically both an initial and an annual fee. 

Management fees: Fees which are charged for the management of the fund. 

Other: Certain products may have additional fees charged. 

Consider using the following free online EAC calculator, offered by 10X as a part of our free online suite of tools for investors to make use of, allowing you to compare the fees that you are paying with your current service provider with those charged by 10X.  

Let’s look at an example of 1% in fees vs 3% in fees to further illustrate its importance. We will assume the following information for this example: 

Monthly contribution: R3,000  

Tax-free savings account lifetime cap: R500,000 (reached in 13 years and 11 months, assuming you contribute the maximum amount each period)   

Investment term: 30 years  

Annual return: 12%  

Annual inflation: 6%   

Contributions will stop after reaching the lifetime cap, but the money will stay invested for the full 30 years, allowing for further potential compound growth. The returns are compounded monthly and adjusted for inflation to determine real values.  

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

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

We can see how a relatively small difference in fees can have a significant impact on the final investment value when compounded over the long term, highlighting the importance of low fees when it comes to growth. This example is just for illustrative purposes, and actual results may vary.  

10X offers a transparent and cost-effective fee structure which is easy for investors to understand, with fees of 1% or less for most retirement products (including the TFSA). We make use of an index tracking investment strategy with a more active approach to asset allocation. At 10X, we focus on growth and excellent long-term returns for our clients.  

Asset allocation within a TFSA – Building for growth and risk  

The way the asset allocation within your TFSA is structured can have an impact on both the risk and returns of your TFSA. Asset allocation refers to the mix of the different asset classes that you are invested in, such as equities, bonds, real estate and cash. Each of these asset classes has a different level of risk and potential for returns. When you invest with 10X, you have the freedom to adjust your underlying portfolio by choosing from a range of carefully curated funds, each with a different asset allocation and geared towards a specific investor profile. 

As such, when choosing a fund, you would consider your investor profile, your risk tolerance levels and timelines for your TFSA. Your risk tolerance level is essentially your risk appetite, and how comfortable you are with any market volatility which may occur, resulting in potential loss of capital. Equities are seen as the most volatile of the asset classes, but also more likely to generate better returns over the long term. They have been shown to deliver returns above inflation by approximately 7% annually over the long term (based on JSE All Share Index performance versus CPI from 1960-2020). Although it is important to note that past performance does not guarantee future results.  

Bonds and cash add stability to a portfolio but are also likely to generate lower returns, with cash likely to generate the lowest returns of all the asset classes, while also being the most liquid of the asset classes. Real estate, also known as property, may also generate some good returns while providing a hedge against inflation.  

Younger investors may have more of an appetite for risk compared to older investors. As a younger investor with longer timelines on hand, you may wish to include a higher percentage of equities in your portfolio, as you are likely to have a higher risk tolerance level. An older investor may prefer a bit more stability in their portfolio and, therefore, look to include more bonds.  

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Diversifying across the asset classes can be a good way to take advantage of the different economic cycles and ensure that you spread your risk. This allows you to take advantage of good market returns in certain asset classes. Diversifying offshore also allows for potential gains from the more vast international market, while also providing a hedge against local market instability in South Africa and depreciation of the rand. 

10X offers a range of carefully selected funds within the TFSA wrapper for you to choose from. These are suited to different investor profiles, so there is sure to be a fund which aligns with your particular needs. We also offer investors the opportunity to invest their TFSA 100% offshore, which may suit South African investors aiming to hedge against local market volatility. 

Final thoughts on tax-free savings accounts  

TFSAs are investment vehicles that have the potential for excellent growth when managed correctly. You should see them as a long-term investment rather than a simple savings account. As such, you should aim to keep your savings invested for the long term, while being sure to strategically select a fund that aligns with your long-term strategy. As an investor, you also want to make sure to regularly review the fees being charged on your TFSA, as fees can play a major role in the potential growth of your TFSA.  

To find out more about our TFSA, feel free to browse through our website or speak to one of our experienced and helpful investment consultants, who will be happy to answer any queries you may have. Get in touch today and grow your tax-free savings with 10X!