Tax free accounts are long term savings (not for emergencies)

From Maya on Money

If there’s one thing the financial industry is good at, it is complicating things that should be fairly simple. Tax-free savings accounts (TFSAs) were meant to be really simple long-term savings accounts for people who wanted to supplement their retirement savings with an investment that was more flexible and accessible.

Yet the number of tax-free savings accounts available and the conflicting information provided, means that many people still do not fully understand how they work or what they are meant for.

Research conducted by Sanlam Personal Finance found that the majority of people (66%) where using TFSAs for emergency savings and 60% of those surveyed invested in a cash deposit account.

This is concerning because although TFSAs are flexible and you can take your money out at any time, that is not the purpose of the investment. The idea behind the tax-free savings account is that it should be used for longer-term investing because that is when the tax advantage is at its best.

Karin Muller, Chief Executive of Sanlam’s Risk insurance business, believes that the high percentage of TFSAs held in cash deposit accounts is partly due to the more aggressive advertising by banks, but also due to its name. “The term ‘savings account’ is very similar to banking terminology,” says Muller who would prefer the term ‘Tax-Free Investment Account’ because there’s no real benefit from using one’s TFSA for short-term savings. In fact, using the TFSA in this way can adversely affect one’s lifetime limit.

A TFSA has a lifetime limit on contributions of R500 000. So you can contribute a maximum of R30 000 a year until your total contributions have reached R500 000 – that is just over 16 years of contributions. If for example, you have contributed R100 000 to the fund, then you only have a further R400 000 that you can contribute. If you decide to withdraw R50 000, you still only have that same R400 000 of future contributions available, even though your current TFSA balance has dropped to R50 000.

It is for this reason that using your TFSA an your emergency fund is not advisable. Emergency funds are by their very nature drawn upon regularly. Over a period of a year, you may contribute R30 000 to your fund but you may also have to withdraw R20 000 to meet emergency expenses. You will not be able to replace that R20 000 in the current tax year as your R30 000 limit has been reached.

Another reason TFSAs should not be used for emergencies, or even for cash investments, is that the real tax benefit is from capital gains. Currently an individual can receive up to R23 800 of interest tax-free each year without investing in a tax-free savings account. Today you could invest nearly R400 000 in a bank savings account earning 6% per annum and not pay tax – so why limit yourself to R30 000 per year in a TFSA? It would take you 13 years of contributions to reach R400 000 and any adviser would tell you that if you are investing for that long a period of time, cash would not be your best option as it will not keep up with inflation. Over these longer periods of time, it is only growth assets such as shares and property (through unit trusts and exchange-traded funds, for example) that will compensate investors for inflation.

It is also over these periods of time that capital gains tax and dividend tax become significant and that is the real benefit of the TFSA. With the incorrect usage of your TFSA for emergency funds and cash holdings, in two to three years’ time you would start to wonder where the tax advantage lies.

More work needs to be done by those institutions promoting tax-free savings accounts to help investors understand the real value and purpose of these accounts.

Myth vs Fact

The survey found that there are still many misconceptions about tax-free savings accounts, especially when it came to the tax treatment and investment options.

While 92% of those surveyed understood that there was a tax saving, not everyone understood how the tax actually works.

  • Tax-free savings are done with after-tax money. The tax benefit is only on the growth of the investment.
  • No tax is paid by the investment fund either. Some people confused the taxation with that of an endowment product where the fund is taxed.
  • Unlike a retirement annuity there is no tax deduction on your income tax.

Many people thought that TFSAs are completely new investments and the majority did not know that other financial providers, not just banks, can offer TFSAs.

  • You can invest in almost any investment product including unit trusts and share portfolios – the TFSA is purely the structure through which you invest so that you do not pay tax on the underlying investment.
  • The returns or interest earned in a TFSA are not lower than other products. In fact, returns could be higher as the fees are more regulated. The tax benefit should provide a return around 36% higher over a 20-year period.

People either felt they did not earn enough, or earned too much, to open a TFSA.

  • You can contribute to a TFSA on a monthly or ad-hoc basis. Many TFSAs have minimum contributions of only R300 per month.
  • While R30 000 per annum may not sound like a lot, when you consider that it equates to R2 500 per month, how many people have that extra money to save each month over and above their retirement savings? If you are able to invest more than R2 500 per month, at least make sure the first R2 500 is invested in a tax-effective way.
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