Opening a tax-free savings account (TFSA) is a great way to start investing.

If there is one investment all South Africans should aim to have it is a tax-free savings account (TFSA).

This is an excellent investment vehicle for growing long-term wealth and there are so many easily accessible, inexpensive options that allow you start investing with as little as R50. You can invest up to R36 000 per year into your TFSA, with a lifetime limit of R500 000.

Tax-free savings accounts were introduced over seven years ago to encourage South Africans to save by providing an opportunity to invest tax free. Although the money you are using to invest has already been taxed, all growth in the investment – including interest, dividends and capital gains – is exempt from tax.

TFSA for retirement

Because your withdrawals from your TFSA are not taxed, it is an excellent product to supplement your retirement funds.

Himal Parbhoo, CEO of FNB Cash Investments uses an example of a 30-year-old who contributes R3 000 per month to a TFSA.

This is invested in a unit trust fund that targets a return of 5% above inflation. By the age of 45, they would have contributed an amount of R500 000. But instead of drawing it and using it, they leave it to continue to grow. By the age of 70, the investment is worth about R2.5 million in today’s value which they can then use tax free to supplement their retirement income.

Create generational wealth

You can leave your child a significant financial legacy by opening a tax-free savings account for them and allowing time to work its magic to grow the money.

You can open an account in your child’s name the day they are born as long as they have a South African ID number. If you contributed the full R3 000 per month for 15 years, your child would have R800 000 by the age of 15.

If the lifetime limit is not lifted, you would stop contributing and leave those funds to grow. By the time your child is 55 years old the investment would be worth nearly R4 million in today’s value, assuming the funds grew at 10% per annum.

While investing R3 000 a month for your child may be a financial stretch for most families, you can start with R500 a month and increase the contribution by 10% each year.

If the investment grows on average at 10% each year, by the time your child is 15 years old the fund would be worth R260 000 in today’s value. If you left that to grow, by the time your child reaches the age of 55 they would have R1.2 million in today’s value.

That is a powerful way to use R500 a month to leave your child a legacy.

Your TFSA is not for emergencies

Do not waste the incredible compounding power of the TFSA by using it for emergencies.

As Ester Ochse, product head, FNB Integrated Advice points out, “a TFSA is not a transaction account and should not be used as such. The idea is to add funds and let them grow over the long term.”

The reason for this is that when you withdraw from your TFSA, you cannot “top up” again as the original contribution is counted towards your lifetime contribution. For example, if you have contributed R72 000 over a period of two years and you withdraw R20 000 for an emergency, it is still deemed that you have contributed an amount of R72 000. If you decide to put back the R20 000 later that same tax year, it would be considered an over-contribution and could be taxed at the 40% rate.

Rather leave contributions untouched to take full advantage of your TFSA.

Investment options

While most banks offer a TFSA as a savings account, this is not necessarily the best place for your longer-term savings. You can already earn up to R23 800 in interest each year before you pay tax (R34 500 if you are 65 or older), so you are not really saving tax by using a TFSA for a short-term savings account that simply earns interest.

You need to be investing for long-term growth through unit trusts or exchange-traded funds that invest in the stock market both locally and abroad. With these funds, the income you earn comes from dividends as well as capital gains. Outside of a TFSA, this income is taxed.

All unit trust companies and platforms that offer exchange-traded funds offer a range of tax-free savings accounts. These include well-know names such as Allan Gray, Ninety-One, Coronation as well as low-cost investment platforms such as Satrix, 10x Investments and EasyEquities.

Unit trust companies tend to have higher monthly minimums of between R300 to R500 a month, while platforms like Satrix and EasyEquities have low to no minimum requirements. FNB offers a very cost-effective TFSA which you open on the banking app and is invested in their range of unit trusts.

If you are considering at TFSA offered by an insurance company, check the fees as some of these products carry high fees if you are not invested for a certain period of time.

All investment companies have a core range of funds which they recommend for tax-free savings accounts which makes it easier to make a choice.

Rather than worrying about what the best fund would be, focus on starting the investment. The sooner you start, the more time you have for your investment to grow.

TFSA Rules

• A tax-free savings account allows you to save without paying tax on the income earned on your investment. This includes any interest earned, dividends received or capital gain made.
• You are allowed to contribute up to R36 000 every year which works out at R3 000 per month.
• The lifetime contribution may not exceed R500 000. That means if you contributed R36 000 every year, you would reach the lifetime limit in just under 15 years.
• Any annual contribution that exceeds R36 000 will be taxed at 40%, so make sure you don’t exceed this limit
• You can have multiple TFSA accounts as long as the total contribution across all of them does not exceed R36 000.

This article first appeared in City Press.