While I was taking a long weekend, looking at things like this:
South Africa’s National Treasury announced the final details of its Tax Free Savings Accounts (TFSA).
Exciting stuff, eh?
The Basic Background
- National Treasury is concerned about the lack of savings amongst middle class South Africans.
- National Treasury is particularly concerned about middle class South Africans cashing in their pension and provident funds early.
- So National Treasury is throwing out a tax bone.
How TFSAs will work
- You get to contribute a maximum of R30,000 a year into an investment product (fixed deposits, unit trusts, and from what I can tell, REITs – subject to some restrictions);
- You can contribute a maximum of R500,000 in your lifetime;
- Your contributions are not tax deductible (boo);
- But all your proceeds and gains are.
The critics are concerned that the limits are a bit paltry.
But this type of savings scheme is not for people that would find these limits immaterial. TFSAs are intended for those of us that aren’t doing much saving in the first place – in which case, anything is better than nothing.
I do have some other concerns:
- I’m not entirely sure why you would choose to encourage the middle class to consume less when the economy is already under pressure. That said, I’m sure that people will generally continue to consume what they consume – and just change their already-existing investing strategies to include some sort of TFSA for themselves and their children.
- I don’t think that the middle class thinks along the lines of “Oh my. A tax incentive that I don’t understand! I must save more to take advantage of it.” or “You know, what’s always held me back before is the taxes on my investments.”
- But you know what is a much bigger obstacle to the saving/investing process? FICA. And FATCA. And all those Big Brotherly things that turn your bank account into a massive exercise of constantly searching for proofs of address.
That aside, I’m certainly not going to say “Don’t take advantage of this on principle”.
I’m a pragmatist. National Treasury is serving up small punnets of fruit. It won’t solve the famine, but we can still make jams and puddings and pastries.
How I Will Run My TFSA
- The sooner it goes in, the better.
- The higher taxed the return, the even more better.
- The bigger my immediate family, the very best.
So the first one is clear: if I save R30,000 on 1 March 2015, it gets to earn a year of tax-free return. If I save R30,000 on 28 February 2016, it doesn’t get to earn a year of tax-free return.
And I think that the third one is also clear: why save R30,000 for myself tax-free and the rest elsewhere when my spouse and children are also eligible for R30,000 worth of tax free savings each.
But the second principle is the interesting one: because what’s the point of tax savings if you’re not going to be subject to very much tax?
- Investment returns are generally limited to: dividends, interest, capital gains and distributions (in the case of REITs).
- Tax on Interest? Your first R23,800 of interest is tax-free. And assuming a 5% interest yield, you’d need to have R476,000 invested before you’re going to be taxed on any interest. So for the most part, you’re not going to have a tax benefit there for quite some time.
- Capital gains? You get R30,000 of capital gains excluded (ie. tax free) each year. So again, probably not the best tax benefit in the short term.
- Dividend tax? Well, companies won’t withhold the 15% withholding tax on dividends for any investments held in a TFSA. So that’s quite a nice saving right there – as it translates into a 18%* boost in your return.
*15% (tax saving) ÷ 85% (after tax dividend) = 17.6% higher return
- Tax on distributions? Well, distributions from REITs are included in your normal income tax calculation – so they can be taxed at the highest marginal tax rate (40%) depending on your tax bracket. And if they’re taxed at 40%, then that translates into a 67%* boost in your return.
*40% (tax saving) ÷ 60% (after tax distribution) = 67% higher return.
And considering that these investments will be indefinitely tax free, you’re looking at compounding impacts.
Let me illustrate that. Let’s say that you’re a top tax bracket man who needs to pick between three different investments, all earning the same after-tax return currently (let’s call it 6% for ease of convenience):
- A Fixed Deposit
- A Unit Trust of low-risk, high-dividend-yielding stocks (let’s say that all gains come from dividends)
- A REIT (let’s say that all gains come from distributions of rental income after expenses)
If you’re going to invest R30,000 a year until you hit the R500,000 cap (in the middle of year 17), then your investment options look like this, after you take into account the tax bonus:
And that’s assuming the same return. Which isn’t really that accurate, because you’d expect:
- Capital growth in both the REIT and the unit trust, which will also be tax-free; and
- Higher yields for those two because of higher risk.
So if we say that the after-tax return of equities is about 10%, and the after-tax return of the REIT is about 8%, then you get this:
It’s part of the trouble with taxes and tax breaks: you get unnatural distortion in the way that markets are meant to work to be efficient and reward risk. In this case, REITs are probably lower risk in a lot of ways – but the tax methods involved are going to reward the investment. It’s the kind of tax construction that results in property bubbles.
But Ignoring The Potential Market Distortions
Let me thoroughly disclaim something else here: this isn’t financial advice. I’m just observing the range of outcomes.
But for my money, I’ll certainly have a tax free savings account. And I’ll be maxing out that allowance each year.
PS: as a final aside, SARS is going to heavily penalise over-contributions, even if it’s by accident. If you put more than R30,000 into the account in a year, then the excess gets you a 40% penalty. Probably for two reasons:
- They don’t want too much saving; but also
- It’s going to be hard to administer (how will they know if you’ve put R30,000 into two different TFSAs? Or more? That kind of things needs to be nipped in the bud by making it hugely punitive if you get caught).