3 reasons a tax-free savings account should be your first investment

Investing for the first time doesn’t need to be scary or overwhelming, writes Wessel Brand, Portfolio Manager at Sygnia Asset Management, as long as you know the secrets to starting out right.

You’ve made it beyond the “Salticrax for the last week of every month” stage of your income-earning life. You’re older but still young, and you finally have a bit of cash left at the end of every month. You know the smart thing to do is to invest, and you want to – but you don’t know where or how to start.

If this roughly describes your current financial situation, you’re not alone. A recent study conducted by data analytics firm Kantar found that most South Africans realise the importance of saving and investing but are put off by the complexity of formal savings and investment options.

Now for the good news: you don’t need to have a lot of money or know anything about investing to make your money work well for you. You can access an easy, simple and safe investment option with little capital and zero knowledge that will deliver between 22% and 42% more growth than more complex, time-consuming investment strategies.

Say hello to the tax-free savings account (TFSA), brought to you courtesy of the South African government.

Introduced in March 2015 to encourage South Africans to save, the TFSA is a 100% tax-free investment vehicle available to all, from newborns to retirees. It allows every citizen to invest R36 000 per year, up to a maximum lifetime contribution of R500 000.

You may have already heard about TFSAs, but judging by the limited uptake of this golden opportunity I suspect most South Africans don’t fully understand the benefits of choosing it as a first-time investment vehicle.

So here are three solid reasons a TFSA should be the first vehicle for any investor, regardless of how much or little you have to invest.

1 | A little makes a lot

The beauty of paying zero tax is that it allows your investment to achieve its fullest potential over time due to the positive effect of compound interest year after year (there’s a reason Albert Einstein apparently described compound interest as the “eighth wonder of the world,” adding, “he who understands it, earns it; he who doesn't, pays for it.”)

While R36 000 a year may not seem like a huge amount, throw the full effect of compound interest into the mix and it can amount to a tidy sum over the years.

2 | Zero expertise is a bonus

Hollywood movies would have you believe that you can time the market by picking one winning stock to hit the big time. Of course, some lucky few bought into Apple in the very early days and are living it large now, but they are few and far between. For the rest of us, slow and steady wins the race – and I have the numbers to prove it!

I wanted to see how a tax-free investment strategy performed in comparison with two common non-tax-free investment strategies. I applied the same amount of money (the maximum tax-free allocation of R36 000 per year up to R500 000 per lifetime) over the same period (30 years) to the same baseline assumptions* for these three investment strategies.

Investor A is a long-term investor who invests their full annual allocation of R36 000 in a TFSA, hitting the lifetime contribution limit of R500 000 in year 14.

Investor B is also a long-term investor but switches underlying investments once every five years to take advantage of market opportunities.

Investor C is an active short-term investor who aims to time the market and pick big winners, switching the allocation of their underlying investments at least once a year.

My calculations show that over a 30-year period, Investor A’s investment will earn 22.5% more than Investor B and 41.9% more than Investor C.

Why Investor A performs better than Investors B and C is explained below (see ‘Crunching the numbers’), but the long and short of it is that you need no expertise or admin effort to make your starter investment work brilliantly for you over time. Just open a good TFSA with low fees (aim for maximum fees of between 0.2% and 0.4%, or slightly higher for more exotic passive funds); pay your monthly instalment or make an annual lump sum investment (up to R36 000 per year) before 28 February each year; and then forget about it. In 20 to 30 years you can pat your younger self on the back for your foresight.

3 | Control what you invest in

A common misconception is that TFSAs are a single or set investment product, like the fixed interest money market accounts offered by most major banks (which I strongly advise against – more on this in part 2 of this article).

A TFSA is an investment vehicle regulated by the South African government. Provided it sticks to certain regulations (e.g. it must have low fees), a TFSA can take many shapes and forms. The underlying investment can be an exchange traded fund (ETF), South African unit trust and yes, those money market and other interest-bearing funds.

With more than 70 ETFs listed on the Johannesburg Stock Exchange and 1 600-plus unit trusts on offer, you can decide whether you want to invest 100% offshore, 100% domestic (SA) or a mix of the two.

Which leads me to the second misconception about a TFSA: it doesn’t have to be a single investment vehicle. There are no restrictions on how to split the annual tax-free allowance of R36 000.

You could, for example, split your full allocation over two or three offshore ETFS, based on factors ranging from your appetite for risk to your moral compass or your niche interests – such as ETFs that invest in clean energy technology, cutting-edge health innovations or even cannabis. Or you could make it super simple and invest in a single TFSA linked to an index fund that has a wide exposure to the broader market, such as the Sygnia Itrix MSCI World Index ETF or a balanced fund like the Sygnia Skeleton Balanced 70 Unit Trust. The choice is, quite literally, yours.

I hope this introduction to the benefits of tax-free investing has motivated you to start your investment journey with a TFSA – your older self will definitely thank you for it.

In part two, I’ll go into more detail about what sort of TFSAs you should and should not consider, along with some important dos and don’ts for first-time investors. Watch this space!

Crunching the numbers

INVESTOR A

Over a 30-year period, Investor A ends with an investment of 22.5% more than Investor B and 41.9% more than Investor C.

This is because Investor A pays no taxes on profits when switching between underlying investments in their TFSA and never loses out to dividend withholding tax. 

INVESTOR B

Delivers 22% less growth than Investor A, because Investor B has to pay capital gains tax on their realised gains and is also liable for dividend withholding tax (20% on all dividends received from underlying investments).

INVESTOR C

Delivers 41.9% less growth than Investor A, because Investor C must include all realised gains with their annual personal income tax. For this calculation I used the South African Revenue Service’s (SARS) lowest tax bracket for a natural person (18%) and included the primary tax rebate for natural persons (R15 714 for the 2022 financial year). The taxable portion will increase if your tax bracket is higher, resulting in even lower returns on your investment.

*Baseline assumptions used:

• Annual contribution: R36 000

• Maximum lifetime contribution: R500 000

• Capital growth: 10%

• Dividend yield: 3%

• Dividends are reinvested at every year end

• Time span: 30 years

• Personal income tax rate: 18% (lowest tax bracket)

• Capital gains tax (40% inclusion rate and 18% personal income tax rate)