How to Become a Tax-Free Millionaire
A practical guide to getting the most out of your TFSA
What I if I told you that investing R3000 per month for 14 years could set you up for life and allow you to not have to invest another cent should you wish to do so.
This can be achieved with some discipline and through the power of a Tax-Free Savings Account (TFSA). A TFSA is an investment vehicle in which you will pay no income taxes, dividends tax, or capital gains on your investments.
Every individual in South Africa qualifies for a TFSA. However, a TFSA has certain limitations of the amounts you may contribute. Every individual is subject to an annual contribution of R36 000 and a lifetime contribution of R500 000. If we crunch the numbers by breaking down our annual contribution, a monthly payment of R3000 (R3000 x 12 = R36 000) will allow us to contribute the maximum allowable amount. Doing this consistently will result in you meeting your lifetime contribution limit of R500 000 in just under 14 years. Once you have reached your lifetime contribution limit you can sit back and let the magic of compound interest work away at growing your nest egg.
Compound interest is the 8th wonder of the world. He who understands it, earns it he who doesnt, pays it. - Elbert Einstein
Tax-free investments may only be provided by a licensed bank, long-term insurers, a manager of registered collective schemes (with certain exceptions), the National Government, a mutual bank, and a co-operative bank. Service providers must be designated by the Minister in the Gazette. As per the current Regulation, only the above are designated.
Once you have taken the first step by deciding to make monthly contributions to your TFSA the next decision you need to make is what to actually invest in. The following investments qualify to form part of a tax-free savings account:
Unit trusts (collective investment schemes)
Retail savings bonds
Certain endowment policies issued by long-term insurers
Linked investment products
Exchange-traded funds (ETFs) that are classified as collective investment schemes.
Using your TFSA to invest in ETF's
For most individuals, an ETF is the best possible investment in a TFSA. An ETF is a basket/bundle of shares (also known as an index) that are traded on the stock exchange. The concept behind this is simple. Individual stocks can go to zero, but over time, the stock market as a whole always goes up. Rather than tracking individual stocks, index funds go up and down according to the entire stock market. So some years it may go down, and some years it may go up but in the long term, it always goes up. Thus making for a safe and lucrative investment opportunity. An ETF is a cost-effective way to diversify by owning the market instead of trying to outperform the market, something most fund managers fail to do.
An example of an ETF is the Satrix S&P 500 ETF(STX500) which trades on the JSE. When you buy this ETF you are buying a basket of the 500 largest companies listed on the New York Stock Exchange. Some of the companies included in the S&P 500 include Apple, Microsoft, Amazon, and Facebook.
Another popular ETF is the MSCI World ETF. The MSCI world is a broad global equity index that represents large and mid-cap equity performance across all 23 developed markets countries. The MSCI world index offers certain benefits over the S&P 500, the most important being global diversification. Thus the index will be less impacted by economic events in the United States since the index is not only exposed to US shares but also a host of shares from other countries. However, the US stock market has produced better returns than other economies and it is for this reason that the S&P 500 is used as a benchmark for investors' returns. Thus while the MSCI may be less risky it may underperform the S&P 500 in the long run as it it has done so in recent years.
Historical Returns of the S&P 500
Over the past 30 years, the S&P 500 was yielded an average return of 9.85% a year. Through the power of compound interest investing in an ETF that tracks the S&P 500 can help you grow your TFSA at an exponential rate.
Lets take a look at how the account will grow to assume we invest in the S&P 500 with an average annual return of 9,85%.
By the end of 14 year period of contributing R3000 per month, we would have maximized our annual contributions and can expect to have a balance of just over R1 million in our TFSA. Our total contributions were however only R500 000 thus our account has grown by over 100%. After we have reached our lifetime contribution is where the true magic happens. This when we have sat back, relax, and watch compound interest go to work. If we left our TFSA untouched for the next 30 years we can expect our account to grow to a whopping R16,5 million tax-free moolah.
A possible investment strategy to set your kids up for life is to open up a TFSA for them when they are born. By contributing R3000 a month until their 14th birthday you can then gift them gift financial freedom should they invest this wisely and leave the money to grow. By age 34 they could have R16,5 million and retire should they wish to do so. If they hold out and decide to hang on to this money until age 50 an extra 16 years would transform that R16,5 million to R78,9 million.