Lets talk about TFSA, baby: Part1/2

In this article, we discuss the ins and outs of TFSA accounts. Part1.

No one likes paying taxes. 15% VAT, 28% company tax, and up to 45% personal income tax on your hard-earned Moolah. Sadly, our investments are not exempt from it either. If only there was a way to beat the system . . .

Introducing our knight in shining armour: TFSA, short for Tax-Free Savings Account. What is it? How does it work? And how can one make the most of it? Welcome, o curious reader. Allow me to illuminate TFSA for you.

What is a TFSA?

Tax-Free Savings Accounts allow individuals to invest without paying taxes on the returns from these investments. What returns am I referring to? (Besides, this is a bear market - havent heard the word returns in quite some time). I am referring to the three types of investment incomes that we normally pay tax on: interest income, dividend income, and capital gains.

Taxable investment incomes

Investments typically attract three types of taxes:

• Interest Tax

Cash and bonds incur interest income. Cash in the form of interest on bank deposits, and bonds in the form of semi-annual coupons (coupons is just a fancy word for interest that you receive from bonds every 6 months). 

• Dividends Tax

Dividends are paid by companies to reward shareholders for investing in them. The bigger the company, the higher the chance to receive a solid, consistent dividend. Dividend income is taxed at 20% in South Africa. 

• Capital Gains Tax

A capital gain is when an asset is sold for a higher price than what it was bought for. In South Africa, 40% of the capital gain from a sale is taxable. For example, if you buy a stock for R10,000 and sell it for R25,000, the capital gain equals R15,000 (R25,000 - R10,000), of which R6,000 (40% of R15,000) is eligible for taxation.

What can you hold in a TFSA?

Managing individual shares can be quite daunting, risky, and time-consuming. Therefore, legislation in South Africa states that you can only invest in collective investment schemes, like Unit Trusts and Exchange Traded Funds (ETFs). 

A collective investment scheme is when your money is pooled together with that of other investors and spread over a range of assets within a fund. The two main advantages of collective investment schemes are that they offer diversification and are managed by professional fund managers.

The following investments qualify to form part of a tax-free savings account:

• Fixed deposits: lump sum in a bank for a fixed period at an agreed interest rate.
• Unit trusts: pools investors' money into a single fund, which is managed by a fund manager.
• RSA Retail savings bonds: bonds issued by the SA Government.
• Endowment policies: life insurance contracts designed to pay a lump sum after a specific term or on death.
• Linked investment products: policies that have life insurance coverage and investment components. 
• Exchange-traded funds (ETFs): Tracks the performance of a bundle of shares.

Our favourite TFSA investment

For beginners, its often best to start out with ETFs. An ETF tracks the performance of a bundle of assets that are pooled together as one. For example, the JSE Top40 represents the biggest 40 stocks in South Africa. Basically, instead of investing in one company, you invest in small bits of many companies. 

Our favourite ETFs include:

• SA shares: Top40 
• US shares: Nasdaq100/ S&P500
• Global shares: Global 1200
• Global bonds: Global Government bond

Summary + Part 2 incoming

A Tax-Free Savings Account (TFSA) is exactly what it sounds like. A way to save without getting taxed on the moolah you make from TFSA investments, including interest, dividends, and capital gains.

The legislation states that you cannot invest in individual shares. You can only invest in collective investment schemes, such as unit trusts and ETFs. 

Next up: TFSA, Part2. We discuss contribution limits and the Ts&Cs regarding withdrawals.