Theoretically, the most efficient option is investing in a retirement annuity (RA) before investing any excess amounts in a tax-free savings plan (TFSA). However, there are other factors that may outweigh the purely theoretical aspects:
• Withdrawal considerations. You can withdraw from a TFSA at any time, and there is no tax on withdrawals. RAs are only accessible at retirement (under normal circumstances), and you need to buy an annuity with at least a part (currently two-thirds) of the accumulated value.
• Asset allocation considerations. There are no restrictions on asset allocation in the TFSA, whereas restrictions apply to RAs in terms of Regulation 28 of the Pension Funds Act.
• Estate planning considerations. While an RA will not form part of your estate, a TFSA will.
It is generally considered good practice to use the TFSA to supplement retirement savings, even if you have not reached your maximum allowable contribution to an RA.
Only use the cash flow flexibility of a TFSA as a last resort
The flexibility of the TFSA is a great benefit. These investments can be used for emergencies, house deposits, school fees etc. However, it is important to remember the following:
• You can’t invest more at a later stage to ‘make up’ for the withdrawal. The contribution limits of R33 000 a year and R500 000 over your lifetime remain.
• TFSAs are not designed to be used for regular withdrawals over the short term. Rather, their value is maximised when you benefit from tax-free compounding in growth assets over the long term.
How to use tax-free investing to complement RA savings
A TFSA can make a valuable and flexible addition to your retirement income. The simplified example below considers an investor who saves in a TFSA, while already having contributed 15% of their salary to an RA from the age of 25 years. The investor retires at age 65, converts the untaxed lump sum portion of their RA to a living annuity and selects a drawdown rate of 6%.
Note that the amount accumulated in the RA will depend on each investor’s age when starting the investment as well as their income. We assume the investors contribute the maximum R33 000 to the TFSA until their R500 000 lifetime limit is reached.
At retirement, the investor could decide to use their TFSA savings as an additional source of tax-free retirement income. The additional monthly income they can add to their RA income from their TFSA is shown below.
Use TFSAs as part of your overall savings plan
You’ll need to consider your financial needs and goals carefully to make an informed choice about the best savings option for you. Remember that to truly maximise the benefits of a TFSA, you need to start investing regularly, and as early as possible – even if the amounts are small to begin with. The sooner you start, the more time your money has to compound and grow tax free. When used as a long-term savings tool, TFSAs can make a meaningful difference to your retirement outcome. A qualified financial adviser can help you understand your options better.
Investing in a TFSA on behalf of minors
A TFSA can be opened by anyone who has a tax number, including a minor. This can be useful for parents who want to start saving for their children. However, be aware that if you exhaust their R500 000 lifetime contribution allowance they will not be able to make their own contributions later in life. On the plus side, they will benefit significantly from the longer period of tax-free compounding!