A tax free investment is often marketed as a tax free savings account (or TFSA for short) by banks and other financial institutions.

A TFSA will only provide a substantial tax benefit if properly utilised. In order to properly utilise a TFSA, the two most important things to remember are:

- Invest as early as possible, and do not withdraw your funds from the TFSA until you have to (hopefully only when you are retired).
- Invest in high growth assets such as exchange traded funds or unit trusts, investing in a fixed deposit which only earns interest will usually not provide any tax benefit.

We discuss these two concepts below.

**Invest as early as possible, for as long as possible**

Young people have by far the most to gain from a TFSA because of the power of compound interest. An individual may invest up to R36 000 per year and R500 000 over their lives into a TFSA.

If you withdraw a contribution from a TFSA the future tax benefits on that contribution are lost forever, as you may not reinvest amounts withdrawn.

So it’s important to remember that **TFSA’s are not for short-term savings**. If you want to save short-term, do so in a normal fixed deposit or unit trust. You will only obtain real tax benefits in a TFSA if you do not touch the investment for multiple decades.

Although it is often easier said than done, trying to commit to putting a small amount aside every month for long-term savings is hugely important and your older self will thank you for doing so.

A good way to ensure that you save an amount every month is to set up a debit order which goes off automatically at the start of the month when you have funds in your bank account.

**Invest in high-growth assets**

Each person under 65 has an annual exemption of R23 800 for interest income while individuals over 65 have an annual exemption of R34 500.

For this reason it is not really beneficial to invest in a TFSA which only pays interest as you may as well invest your money in an interest earning account which is not a TFSA and utilise your annual interest exemption.

The benefits of a TFSA are when you invest in a TFSA which grows exponentially over a long period of time while also possibly receiving dividend income. Once you withdraw your funds from a TFSA after substantial capital growth you will enjoy the benefit of not having to pay any capital gains tax when you withdraw your money.

**Example**

In these example we do not yet consider contributions to pension funds or retirement annuities which we will get to in the next lesson.

S’fiso is a 25 years old and he has inherited R30 000 from his father who passed away. S’fiso wants to save the money for his retirement and plans to withdraw the proceeds of the investment when he turns 65.

Although there are many options available for S’fiso, for simplicity we consider four options available to him and compare the tax implications.

- Invest the R30 000 into a fixed deposit account, which earns 6% interest per annum compounded monthly
- Invest the R30 000 into a tax free savings account which earns 6% interest per annum compounded monthly
- Invest the R30 000 into an exchange traded fund which tracks the JSE Top 40 which is not a tax free savings account
- Invest the R30 000 into an exchange traded fund which tracks the JSE Top 40 which is a tax free savings account

*Option 1: Invest R30 000 in a normal fixed deposit account*

When S’fiso turns 65 and withdraws his investment from the fixed deposit account, the account will have a balance of **R328 723,60**.

In the last year before S’fiso withdraws the money, the investment will have earned R19 097,08 interest. This is still less than the R23 800 annual interest exemption applicable to individuals under the age of 65. Assuming that S’fiso has not earned interest from another source, this means that all the interest income earned on this investment is less than the annual interest exemption and therefore all interest earned on this investment will be tax free.

S’fiso will be able to withdraw the full amount of **R328 723,60 **without any tax consequences.

*Option 2: Invest R30 000 in an interest earning tax free savings account *

The growth of the investment will be exactly the same as in option 1 above. Because the investment was in a tax free savings account, all interest will be tax free and S’fiso will also be able to withdraw the full amount of **R328 723,60 **without any tax consequences.

Option 2 does not provide any additional benefit for S’fiso as opposed to option 1, and this illustrates why a tax free savings account does not provide much benefit if your tax free savings account is only earning interest.

*Option 3*: *Invest R30 000 into an ETF which tracks the JSE Top 40*

Investing in a JSE Top 40 ETF is a riskier option than investing in a fixed deposit, where your returns are guaranteed.

However, if we use the growth rate of the JSE Top 40 over the last ten years of 8,17% per annum (which is much less than in previous decades), S’fiso’s investment will be worth **R694 393,40 **when he turns 65.

Because, in this option, S’fiso did not invest using a TFSA, when he realises this investment, it will be a disposal for capital gains tax purposes.

If we remember how capital gains tax is calculated, as was explained in Lesson Two (insert link to topic), we will determine the tax consequences of the investments as follows:

Base cost of the asset = R30 000

Proceeds = R694 393,40

Capital gain = R664 393,40

Net capital gain = R664 393,40 – R40 000 = R624 393,40 [we subtract the annual exclusion applicable to natural persons]

Taxable capital gain = R624 393,40 * 40% = R249 757,40 [we multiply the net capital gain by the 40% inclusion rate applicable to natural persons]

Therefore S’fiso would have to include an amount of R249 747,40 in his taxable income in the 2062 year of assessment (the year in which S’fiso turned 65 and withdrew the funds).

If we assume that S’fiso earns no other income in the 2062 year of assessment (but ignoring any rebates), S’fiso would have to pay tax of R47 640,91 using the 2022 year of assessment’s tax rates (which will of course not be applicable in 2062).

In this option we see that S’fiso has enjoyed substantial capital growth in his investment, but because he has to pay R47 640,91 in normal tax (as a result of the capital gain), his net return is **R646 752,50**.

*Option 4: Invest R30 000 into a JSE Top 40 ETF Tax Free Savings Account*

The growth in S’fiso’s investment will be identical to option 3 above, however because S’fiso had invested the money in a tax free savings account, he will not have to pay any tax on the capital gains.

The above example demonstrates the benefit of using a tax free savings account to invest in a growth asset for a long period of time. In the above example a comparison between option 3 and option 4 demonstrates that S’fiso was able to enjoy a tax saving of R47 640,91.

Now that we have seen the benefits of using a tax free savings account, in the next topic we will provide some practical advice on how to set up a tax free savings account.

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