Let's talk about the TFSA

How the Tax-Free Savings Account is a powerful wealth-building hack for families.

Image Credit: Photo by Puwadon Sang-ngern from Pexels

For most of us, wealth is not about flexing, consuming more, or buying happiness. It is simply about buying back our time, so we don’t have to work to live and can actually just live. Maybe some of us want to travel, explore the world, or spend all our time reading books or solving interesting problems. And I would bet some of us just want to have the time to spend with our children or leave them a legacy of financial independence, even if we don’t achieve it ourselves.

If that is you, then the Tax-Free Savings Account (TFSA) is for you. The first thing I should say is that the TFSA is not a replacement for a retirement account, both have unique advantages, although if you don’t earn enough to meaningfully contribute to both, I would choose the TFSA first. Secondly, the TFSA is a statutory account, meaning it was created by the government in 2015 as a special type of account meant to encourage savings.

This account is quite simply a compounding machine. With a TFSA, you can contribute up to R36,000 annually (this should get adjusted upwards to account for inflation hopefully) and R500,000 throughout your lifetime. It’s important to emphasize that these limits apply to your contributions, not the capital, interest or dividend gains from your TFSA.

So the investment gains (capital gains, interest, dividends) are unlimited and tax free. The normal capital gains, income, dividend, interest taxes don’t apply to a TFSA. Which means the money you get within the TFSA is received, reinvested all without being taxed, and it also doesn’t count towards your annual or lifetime limits as long as you keep it within the TFSA.

But you must be careful, the penalties for exceeding the limits are quite severe, so you want to make sure you keep track of your annual and lifetime limits. Many companies are selling TFSA accounts without caring if we exceed the limits, or if the account being sold is the best use of the TFSA.

A bank TFSA account is one of the worst uses of this wonderful tool in my opinion. Equities (shares) are by far the best way to grow wealth and maximise the tax advantages of a TFSA. While there are a few options here (including the Franc app), the absolute best TFSA experience I know of is the EasyEquities TFSA account. Not only can you invest in a wide range of equity instruments (you can’t invest in individual shares in a TFSA, but you can invest in ETF’s and unit trusts), EasyEquities also keeps track of your annual limit for your, although you still need to keep track of the lifetime limit yourself.

This shouldn’t be too hard if you only have one TFSA and it’s on EasyEquities. The limits apply across all your TFSA accounts, rest assured that SARS will apply the penalties if you manage to generate any significant amounts of wealth in your TFSA, so it pays to do things right from the beginning.

Plus you can be diversified within your EasyEquities TFSA. Not only do you have access to a wide range of equity ETFs, you can also buy government bonds, this more than negates any advantage of a bank TFSA account since government bonds usually have higher interest rates than bank accounts. You can also get cheap (prime + 3%) collateralised loans via your EasyEquities ZAR and TFSA accounts, this can help with liquidity issues and mitigate against the pressure to sell your investments, just don’t use it irresponsibly.

The truly game-changing feature from the EasyEquities is that you can create accounts for your kids right from the app, and it’s quick and easy, it takes less than 5 minutes to do so. This includes the TFSA. So thinking about it in terms of building wealth, for each of your kids, you can save R500,000 tax-free. So if you have 4 kids, this can be potentially be R2 million saved plus any investment gains, just for the kids, add two parents and this goes up to R3 million.

This means you can set up your kids inheritance while you are still alive and give them a big head start. At maximum yearly contributions, it takes about 14 years to reach the R500,000 lifetime limit. So the earlier you start, the better it is for them, it just means they have even more time to compound their wealth.

Let’s consider an example. Say you start investing the maximum R3000/month for your 5 year old child, by the time they’re 19 years old, if we assume a conservative 8% growth rate, they will have about R894,000 in their TFSA. Nearly a millionaire before they reach 20. Some parents will choose to use this money for their university studies, that is fine, but I think you must have a longer horizon than that when it comes to the TFSA, you want this compounding machine to work for you or your child for life.

I want to emphasize at this point that you should never, ever take out money from your child’s TFSA (funding their studies after the limits are reached is an acceptable exception to this since it benefits the child, but I don’t recommend even that), this will punish your child by reducing their lifetime limit. The costs can be severe, even a small amount can be worth a lot if considered in the light of compounding over time. Don’t open a TFSA for your child if you’re going to take anything out, the TFSA is very much a contribute-and-forget type of account.

So what is my favourite TFSA strategy? Well, for me and my wife, I initially set up our accounts to prioritise dividends. The thinking is that since we’re older, we want growth but we also want to get to a point where we can extract money from the TFSA through dividends. At first we invested in the Coreshares Divtrax ETF, exactly for this reason, but this was shut down shortly after 10x took over the ETF unfortunately.

So now we are invested in the RAFI 40 ETF. I chose RAFI 40 because the ETF composition is weighed via quality factors instead of market cap (it has the same shares as the JSE top 40, only the weighing methodology differs). I will explain what this means in a future article (please remind me if I forget). Since we bought the RAFI 40 ETF last year, it has delivered more than 32% in gains, of course I don’t expect it to deliver such returns every year.

For our kids, we also invested in the RAFI 40. But for some of them I chose the JSE top 40 (market-cap weighed, that’s the standard weighing methodology for broad market ETF’s like the JSE top 40), which has also done quite well. Practically, we are all invested in the same TFSA strategy as a family because we lost the ability to invest in the dividend strategy. But RAFI 40 still delivers some decent dividends.

Ideally, you would never sell the capital in your TFSA. Just take out any dividends you may receive (only start taking out dividends a few years after reaching the lifetime limit of contributions to maximise compounding), it’s such a powerful compounding tool, you don’t really want to interrupt it. I hope this article gets you started building wealth for your family, let me know what your thoughts are, ask any questions you may have in the comments.