The impact of early withdrawals on investment growth and contribution limits in tax-free savings accounts (TFSAs)

Tax-free savings accounts are investment vehicles that were introduced in South Africa in 2015 as long-term savings tools that incentivise South Africans to save. As the name might suggest, tax-free savings accounts allow your funds to grow over time without being liable for capital gains tax, tax on interest or dividends withholding tax. This allows for all of the returns to be reinvested and grow in the investment account. You are also not taxed on withdrawals from your tax-free savings account. These withdrawals are flexible and can be made at any time. 

Tax-free savings accounts do come with annual limits as well as lifetime limits, so it’s important that these aren’t exceeded, as penalties are then imposed. This article will look at TFSA contributions, the rules governing them and the impact of withdrawals in more detail. 

Understanding TFSA contribution limits 

Tax-free savings accounts come with limits on contribution amounts. Annual contributions are a maximum of R36 000 or R3000 per month with a limit of R500 000 allowed in contributions over a lifetime. If these limits are exceeded, penalties of 40% will be imposed on the excess contributions.  

None of the returns made on the tax-free investment are counted as part of your contribution room, and therefore do not form part of your maximum limit allowed. Contribution room refers to the maximum amount that you are allowed to contribute to your TFSA. You are allowed to have more than one TFSA account, but remember that the contribution limits are a sum of all of your TFSAs.  

For example: If you invest R10 000 in one TFSA and R36 000 in another TFSA in the same year, you will have a total contribution amount of R46 000. This means you would have exceeded the limit by R10 000 and you will be charged 40% on this amount, which means you will pay R4000 in tax. 

As the returns made on your TFSA are not taxed, all returns generated can be invested right back into the TFSA account. This allows the funds to compound and grow further over time than would otherwise have been the case if tax had been deducted.  

By contributing the maximum amount allowed and not withdrawing funds, you would hit the R500k limit within about 14 years. Leaving that amount to compound in high-equity funds over the following 20 years would lead to a very healthy amount of money, which makes a TFSA one of the best options for building wealth for your children. 

If you don’t contribute the maximum contribution amount in one year, this doesn’t mean you can contribute more the following year. You are allowed to contribute a maximum of R36 000 per year and if you don’t maximise this, it doesn’t roll over to the following year. 

Let’s look at an example to illustrate the benefits of the TFSA and, by maximising your contributions, the rewards that you can reap over the long term: 

Best-case scenario:  

You invest the maximum annual amount each year and do not make any withdrawals during the investment term. 

Gross investment return: 12%  

Inflation rate: 6%  

Fees: 1% p.a. 

Let’s imagine R36 000 invested for 13 years, R32 000 invested in year 14. 

The real value in today’s money (i.e. taking inflation into account) at the end of the investment period is R998,115.90. 

Now, compound that amount at 6% real return over 20 years. The value of that investment is now around R2.7m in today’s money! That is the power of compound interest. 

  The Impact of early withdrawals 

Early withdrawals mean that your TFSA has less accumulated funds to compound and grow over time. It is best to leave the funds invested and allow them to compound over the long term, as this will result in a larger capital amount available for your retirement and/or other financial goals in the future. 

There are no costs or penalties associated with withdrawals and you have flexibility to withdraw if you need to. If you do, it’s important to plan your withdrawals carefully. Any withdrawals have already been deducted from your lifetime contribution room so you won’t be able to contribute these funds again. Let’s look at the effect of frequent and early withdrawals from a TFSA compared to a situation where you do not make any withdrawals. 

Imagine an investor who has good and bad years in terms of savings. Some years, they can invest and other years, not; withdrawing funds instead. 

Annual contribution: Year 1 and Year 2 - R36 000. Year 2 - no contribution. Year 3 - R36 000  

Year 5: R36 000. 

Let’s imagine they continue in the pattern of investing the maximum amount every 2 years - ending in year 20. 

Withdrawals: Every 3rd year, the investor withdraws R25 000 - up to year 18 

Investment return: 12% 

Inflation rate: 6% 

Fees: 1% per annum 

Time period invested: 30 years. 

The real value in today’s money, as at the end of the investment period, is R580,384.65. 

As you can see, in this scenario, the net result is not much greater than the sum of the annual contributions, so the investor ends up losing out on a lot of the benefits offered by the TFSA. 

Fees and their impact on discretionary investment products  

There are certain fees you can expect to find associated with your TFSA. Even though you are benefitting by avoiding tax on your returns, high fees will, however, negatively impact the growth and compounding of your investment over time. You would generally expect to see fees such as administration fees, management fees and possibly also advisor fees if you are using an advisor. 

Administration fees: These are the fees that are charged for the general administration of the fund. This will be related to administrative work, such as tax and reporting. 

Management fees: These refer to the fees charged by a fund manager who actively manages the fund. 

Advisor fees: Fees which are charged by an advisor for their advice. There would usually be both an upfront fee and an ongoing fee. 

When comparing service providers, it’s wise to choose a provider that offers low fees. This will allow your TFSA to reap the benefits of compound interest and build on this over the long term. High fees deplete your funds, especially when compounded over time. 10X offers transparent, low fees and also does not charge any platform or advisor fees, making it a competitive option. You can find out more about 10x’s Tax-Free Saving Account here.  

Effective Annual Cost (EAC) 

The Effective Annual Cost (EAC) was implemented by ASISA as a way in which to compare products and the costs involved with them. It refers to all the costs and fees associated with a particular investment vehicle over a one-year period of time. This useful calculator will help you compare and evaluate the costs associated with your investment products. 

In order to maximise your returns, you would want the lowest EAC possible on your TFSA. A higher EAC will deplete your returns and affect your capital growth over the long term. You want to ensure that you select a TFSA with a low EAC. If you discover the costs involved with your TFSA are high, you can look into transferring to a different service provider, which is a simple process to initiate. It’s important to ensure that this is a direct transfer, instead of withdrawing the funds and reinvesting them, which would then affect your contribution room.  

Inflation's impact on investment returns 

Inflation has a negative effect on our savings. Historically in South Africa, inflation has been around 5% to 6%. Although this may sound nominal, when compounded over time this can have a significant effect on our investment returns. Effectively, it means that each year you are able to buy a smaller basket of goods and services with the same amount of money.  

Ideally, you would want to see your TFSA outperform inflation by a healthy margin. To do this, you need to make sure that you implement strategies to achieve these goals. You would want to ensure a diversified portfolio that is able to take advantage of any good market returns in certain asset classes and mitigate against any losses in other asset classes. You would generally look at investing in a portfolio that consists of equities, bonds, real estate and cash. You would also want to include a certain percentage of equities in your portfolio as these have shown to outperform inflation over the long term. This would depend on your financial needs and risk tolerance.  

Fund Performance vs. Net Investment Returns 

When comparing the performance of your investment, you need to ensure that you look at the Net Investment Returns rather than the Fund Performance. The Fund Performance refers to the total returns before any costs or fees have been deducted. The Net Investment Returns are your returns after all costs have been deducted, so this is effectively the money in your pocket at the end of the day (without accounting for inflation, obviously). The Net Investment Returns will show you the whole picture and allow you to effectively compare investment products. 

Asset allocation strategies within a TFSA  

Asset allocation is an important tool to use when thinking about achieving your investment objectives. Depending on your risk tolerance and time horizons, you might consider going all-in on equities, or perhaps, if you sough more stability and less risk, a more balanced portfolio containing equities, bonds, real estate and cash. Your asset allocation is usually tailored to your needs as an individual whilst also looking at your risk tolerance and the time spans in play.  

You might also look at investing a percentage of your TFSA offshore, allowing you to take advantage of international market gains as well as mitigate against any volatility in the South African market. South Africa makes up less than 1% of the global economy so getting exposure to global markets might be a good thing to consider. By diversifying your TFSA, you mitigate the risks of underperformance in any one asset class or market. 

Practical steps for managing TFSAs effectively 

It’s important to try and maximise your contributions to take full advantage of the tax savings afforded as well as to maximise returns over time. If you aren’t contributing the maximum, then you aren’t maximising the tax-free growth available.  

You also want to avoid withdrawals unless absolutely necessary. Tax-free savings accounts should be seen as long-term investments, which are only dipped into if there is an emergency. If you do withdraw funds, it is vital to remember that you can’t add those contributions in again. By regularly reviewing your TFSA, you can keep track of its performance and adjust the asset allocation accordingly whilst taking your financial needs and goals into account. 

10x TSFA account  

The 10X TFSA is a savvy tax-free savings account to use. There are a number of benefits to this TFSA which include: low fees, diversified portfolio options to choose from, transparent reporting, easy sign-up, as well as the ability to manage your investment online, and - most importantly – a history of benchmark outperformance. The minimum monthly contribution amount is R500 and for a lump sum contribution, the minimum amount is R1000. There is flexibility and you can amend monthly contributions as you wish. Get in touch with the experienced and knowledgeable investment consultants at 10X to find out more.