The article was written by Jaco Prinsloo, Certified Financial Planner at Alexander Forbes Financial Planning Consultants (updated 31 January 2022)
The benefits of saving are well known, as are the tax benefits offered by tax-free savings accounts (TFSA) and retirement annuity funds (RA). But what is unclear is which savings vehicle is better. Before we look at what the benefits of each, let’s look at factors to consider when choosing between a TFSA and an RA.
What is the difference?
The TFSA was introduced by the National Treasury to encourage South Africans to save in an easy, flexible and affordable way for future expenses and long term investment goals. To allow self-employed individuals and investors facing a retirement shortfall to save in their personal capacity, specifically for retirement, RA’s were created.
The tax benefit
Both TFSA’s and RA’s allow you to grow your savings tax-free, meaning there is no interest, dividend, income or capital gains tax payable on the investment growth. The tax implications on contributions and withdrawals are, however, quite different.
Contributions and withdrawals
With a TFSA, you can start from saving as little as R250 per month or make a lump-sum contribution of up to R36 000 per tax year for 15 years up to the lifetime limit of R500 000. Any contributions over the limits are taxed at 40%.
Unfortunately, there is no tax saving on the contributions you make to TFSA’s, but you can withdraw your savings as a lump sum or as a monthly income tax-free. There is no minimum investment period, but the penalty for withdrawing your funds is that any funds withdrawn cannot be replaced and permanently reduce your R36 000 annual and R500 000-lifetime limits.
An RA allows you to legally reduce your income tax by your contributions with a maximum up to 27.5% of your taxable income or R350 000 per tax year. The tax deduction effectively acts as tax savings rewarding you for making provision for your retirement. Although there are no contribution limits, any non-deductible contributions will be rolled over and deducted in the following tax year.
From the age of 55, you can retire and convert your RA savings into an income in the form of an annuity. At least two-thirds of your RA has to be converted into an income if the fund value is more than R247 500 at retirement. The income from the annuity is subject to income tax. The remaining one-third can be taken as a cash lump sum. Once in your life, you will receive R500 000 tax-free, and the balance will be taxed on a sliding scale of between 18-36%.
Both TFSA and RA’s have access to multiple asset classes eg, local and global cash, bonds, property, and shares. To protect investors, the RA’s are regulated by the Pensions Fund Act, which includes Regulation 28. With the restrictions of Regulation 28, there are certain limits on where and how much you can invest. For example, you can only invest 30% offshore and up to 75% in company shares. The TFSA can be any one of a range of underlying investment vehicles governed by their respective laws. It is not subject to Regulation 28, which means you can invest where you want and as much as you want within the limits in any asset class.
Creditors and Estate duty
An RA protects your savings from creditors and estate duty by distributing your savings directly to the nominated beneficiaries once approved by the trustees of the fund. Any unclaimed deduction made after 1 March 2015 to your RA may be included in your estate. A TFSA offers no protection against creditors, and if invested in a life policy, it will be paid directly to the nominated beneficiaries on death; otherwise, it will be paid to your estate. If your estate is worth more than R3,5-million estate duty could be payable.
The better option?
If you are paying tax on your income, are comfortable with Regulation 28 and can afford to keep your money invested until at least the age of 55, an RA might be the better option because of the tax-saving on the contributions you receive.
If you want to invest more in a specific asset class like offshore equity to increase your global exposure, and want access to your funds, a TFSA might be the better option due to the flexibility the investment offers.
Why not use both?
Combining an RA with a TFSA reduces your income tax while saving and provides you with tax-free withdrawals on withdrawal. This strategy also allows you to escape the restrictions of Regulation 28 by making use of the TFSA flexible asset allocation to increase your total offshore or specific asset class exposure based on your investment goals.
Asking which investment is better might be the wrong question as both the TFSA and the RA offer unique benefits that should be included in your overall investment strategy. The choice will depend on you, your circumstance, and your investment goals, and consulting a certified financial adviser will help guide you. Whichever option you choose, by choosing to save, you have already made the right choice.