Tax-free savings accounts: how they work and who they suit

What a tax-free savings account is

A tax-free savings account — often shortened to TFSA — is not a single product. It is a type of account, created by government to encourage South Africans to save, that different financial institutions are allowed to offer. What goes inside it can vary: some accounts hold cash deposits that earn interest, others hold unit trusts or exchange-traded funds that invest in shares, bonds and property, and some offer a mix.

What these accounts share is a set of rules. You contribute money you have already paid income tax on, you can generally get to your money when you need it, and whatever that money earns while it is inside the account is not taxed. In exchange, there are limits on how much you may put in.

Every person, including a child, has their own allowance — a point we come back to below.

What “tax-free” really means

Outside a tax-free savings account, investment returns can be taxed in several ways. Interest above an annual exemption is added to your taxable income. Dividends from shares usually have dividends tax withheld before they reach you. And when you sell an investment for more than you paid, capital gains tax may apply.

Inside a tax-free savings account no South African tax applies to any of them. Interest, dividends and capital growth are free of income tax, dividends tax and capital gains tax, and so is the money you eventually take out.

Two things are worth being clear about. First, the contributions themselves are not tax-deductible — unlike contributions to a retirement annuity, which may reduce your taxable income within certain limits. Second, tax-free does not mean risk-free. If the account holds investments linked to the market, its value can fall as well as rise. The tax treatment changes what you keep of any growth; it does not create the growth.

In the early years the tax saving tends to be small, because there is not yet much growth to tax. It is over long periods, as growth builds on growth, that the benefit can become meaningful.

The limits — and the penalty for going over

There are two limits: a maximum you may contribute in any one tax year, and a maximum you may contribute over your lifetime. Both are set in tax law and announced in the national Budget, and they can change, so we do not quote them here. Confirm the current figures with your adviser, your product provider or the South African Revenue Service (SARS) before you contribute.

A few details catch people out:

• The limits apply to you, not to each account. If you have accounts with more than one provider, your contributions to all of them are added together.
• The tax year is not the calendar year. It runs from the beginning of March to the end of February.
• An unused annual allowance does not carry over. If you contribute less than the annual limit this year, you cannot add the difference next year.
• Only contributions count. Growth inside the account does not use up any of your limit.

If you contribute more than the annual or the lifetime limit, SARS levies a penalty tax on the excess. It is charged on the amount you over-contributed and can undo a good part of the benefit you were hoping for. No single provider can see what you have paid in elsewhere, so keeping track is your responsibility.

Why a withdrawal costs more than it seems

You can generally withdraw from a tax-free savings account when you need to, and the withdrawal itself is not taxed. The catch is what happens afterwards. The limits count what you put in, and a withdrawal does not reduce that count. If you take money out and later want to replace it, the replacement is treated as a brand-new contribution.

Put simply, limit that has been used stays used. Someone who dips into the account regularly and tops it up again can reach their lifetime limit with far less money actually invested than they expected. For that reason it is usually sensible to keep emergency savings somewhere else and to treat a tax-free savings account as money you intend to leave alone.

Who it may suit

A tax-free savings account is not right for everyone, but it tends to fit these situations well:

• Long-term savers. Anyone with a goal that is many years away and the discipline to leave the money invested. Time is what gives the tax saving room to matter.
• Parents and grandparents saving for a child. An account in a child’s name can be given a very long runway. Bear in mind that contributions use up the child’s own lifetime limit, and that the money belongs to the child. Money paid into a child’s account is a gift to the child, so ask about donations tax if the amounts are large.
• People adding to their retirement savings. Contributions to a retirement annuity or employer fund can reduce your taxable income, which a tax-free savings account cannot, but access to that money is restricted. A tax-free savings account can sit alongside it as a more flexible pot. Which to prioritise depends on your circumstances.

It may be less suitable for money you will need soon. And if you are carrying expensive short-term debt, paying that down is often worth discussing first.

Common mistakes

1. Using it as an emergency fund.Every withdrawal permanently gives up limit that you cannot earn back.
2. Losing track across providers.Two debit orders with two providers can quietly add up to more than the annual limit.
3. Withdrawing in order to switch.Moving between providers should be done as a transfer, not as a withdrawal followed by a new deposit.
4. Holding only cash for a very long-term goal.Cash has its place, but part of the interest you earn is already exempt from tax outside the account, so the shelter may add little. Whether growth assets suit you depends on your time horizon and how much movement in value you can live with.
5. Forgetting that a child’s limit is the child’s.What you contribute in their name counts against their lifetime limit; as adults they cannot start again.

How VyroPlus helps

VyroPlus is an authorised Financial Services Provider based in Kimberley, and investments are one of the eight areas we help with. A conversation about a tax-free savings account usually covers:

• your goal, your time frame and how much movement in value you are comfortable with;
• how a tax-free savings account fits with what you already have — retirement savings, cover and emergency money;
• the costs, the access rules and the tax treatment, explained in plain terms before you decide anything;
• a contribution plan that is designed to stay inside the limits, and how reviews could work as your life changes.

There is no obligation, and no return is ever guaranteed. The aim is that you understand what you are choosing and why.

Questions to ask

Before you open or add to a tax-free savings account, it helps to have answers to these:

• How much of my annual and lifetime limit have I already used?Add up your contributions across every provider, not just one.
• What is actually inside the account?Cash, unit trusts, exchange-traded funds or a mix — and does that match the time you have?
• What will it cost me?Ask for every fee in writing, including the costs of the underlying investments.
• What happens if I need the money early?How long a withdrawal takes, and how much limit you would be giving up for good.
• Can I transfer it later?Whether the provider supports a formal transfer, so that you never need to withdraw in order to move.