Two years ago, at around this time, I had a long weekend of fishing and missed the official budget speech announcement of Tax Free Savings Accounts (TFSAs). I’ve just had another long weekend of fishing, and it felt oddly appropriate to do a quick update of where we stand.
Tax Free Savings Accounts: Where We Were
When TFSAs were first introduced, here were the rules:
- You could contribute a maximum of R30,000 a year into an investment product (fixed deposits, unit trusts, and REITs* – subject to some restrictions);
*Real Estate Investment Trust units. If you’re interested, I’ve written about those here, here, here and here.
- You could 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 were concerned that the limits were a bit paltry. But this type of savings scheme is not really meant 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.
Tax Free Savings Accounts: But What To Invest In Though?
Investment returns are generally limited to: dividends, interest, capital gains and income distributions (in the case of REITs). And obviously, you want to max out your tax saving advantage. So here are some points that I made at the time (using old tax laws):
- The 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 saved before you’re going to be taxed on any interest (assuming you earn no other interest). So for the most part, choosing an interest-bearing investment for your TFSA means that you’re not going to have a tax benefit there for quite some time.
- What about capital gains? Well, 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.
- What about 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.
The 2017/2018 Tax Year Updates
Here’s how all of that has changed:
- Annual contribution limits are now R33,000.
- The top marginal tax rate is now 45%.
- The dividend withholding tax rate is now 20%.
So while most of what I said still remains true, the potential return ‘boosts’ have shifted:
- Investing in dividend-yielding Unit Trusts and ETFs will have a 25%* boost in their return.
*20% (tax saving) ÷ 80% (after tax dividend) = 25% higher return
- Investing in REITs mean that you could be getting a return boost as high as 82%.
*45% (tax saving) ÷ 55% (after tax distribution) = 82% higher return.
Which is, you know, nothing to sniff at. In fact, it’s almost like being able to have your own little tax haven account.
Rolling Alpha posts opinions on finance, economics, and sometimes things that are only loosely related. Follow me on Twitter @RollingAlpha, and/or please like the Rolling Alpha facebook page at www.facebook.com/rollingalpha.