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Busting the myths about tax-free savings accounts

Personal Finance

A survey by Sanlam of more than 400 people found that many of them, including those who have tax-free savings accounts, have misconceptions about these accounts. Of the 255 people who were aware of the accounts, only two could correctly identify all the myths and facts about tax-free accounts presented to them on a questionnaire.

The survey found that many people believe the following myths:

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‘There is no limit to how much you can invest.’ The Sanlam survey found that some people, even those with tax-free savings accounts, mistakenly believe there is no limit to how much they can contribute to these accounts.

The fact is that you can contribute up to R30 000 a year (R2 500 a month), or up to R500 000 over your lifetime. It will take you more than 16 years to reach the lifetime limit if you contribute R30 000 a year.

Although there is a limit on how much you can contribute, there is no limit on the returns your investment can earn.

Your contributions will eventually add up to the annual or lifetime limit even if you make withdrawals from your savings. In other words, withdrawals are not deducted from the tally of your contributions when determining whether you have reached your annual or lifetime limit.

You can contribute a lump sum or a recurring amount every month within the annual and lifetime limits.

‘Contributions tax-deductible.’ Some of the Sanlam survey respondents incorrectly believed that contributions to tax-free savings accounts were tax-deductible. The fact is that the tax benefit is applied to the growth on your savings, not the amounts you contribute.

Some respondents who knew that contributions to tax-free savings accounts were money on which tax had already been paid concluded that the accounts were not worthwhile. But this is not true, because the tax benefit lies in the growth on the savings, be it in the form of interest, dividends or capital gains.

If your investment is not in a tax-free savings account, any interest earned above the annual interest exemption will be taxed at your marginal tax rate, and dividends will be taxed at 15 percent.

Any capital gains you make above the annual exemption of R40 000 will attract CGT. The actual rate at which you pay CGT depends on your marginal tax rate, but the maximum effective rate for individuals who are on the highest marginal tax rate is 16.4 percent.

The Sanlam survey also found that some people believed their savings in a tax-free account were taxed by the product provider. But this is not true.

‘You get tax-free savings accounts at a bank.’ Most of those surveyed knew that banks offered tax-free savings accounts, but some mistakenly believed that these products were available exclusively from banks.

Fewer people knew that most investment companies offer tax-free accounts and fewer still that these products are also available from life assurance companies.

The confusion over which product providers offer tax-free savings accounts may be because most people associate the term “savings account” with bank products.

The array of tax-free savings accounts now includes bank deposits, unit trust funds and exchange traded funds (ETFs), and the providers range from banks and unit trust companies to investment platforms (linked-investment services providers), life assurance companies and stockbrokers (for ETFs, but not other shares).

Intellidex’s research identified 27 providers of tax-free savings accounts. It also found that most tax-free accounts (59 percent) have been in the form of cash deposit accounts at banks. Only 13 percent of accounts are with stockbrokers, 13 percent with unit trust companies, and 15 percent with life companies.

The tax-free savings accounts offered by banks are typically call accounts or fixed deposits, with interest rates ranging from nothing (on small amounts) to 8.4 percent.

A bank account is typically unsuitable for long-term savings, because the returns are often below inflation, which means your money will lose value over time, or only just above inflation, which means your returns will be low after inflation.

Other providers, including stockbrokers and unit trust companies, offer investments with the potential to earn higher returns.

In addition, if you use a bank’s tax-free savings account, your only tax saving will be the income tax on the interest, because bank accounts do not attract dividends tax or CGT.

Tax on interest is not inevitable without a tax-free savings account, because the annual exemption on interest income is R23 800 if you are under 65, or R34 500 if you are over the age of 65.

The interest exemption will not be increased, which means it will be eroded by inflation each year. However, you will have to save R30 000 for a few years before your interest income exceeds the exemption.

‘You can have only one tax-free account.’ Contrary to what some respondents to the Sanlam survey believed, you can have more than one tax-free savings account. You can open as many accounts as you like. However, your contributions to all your accounts are limited to R30 000 a year or R500 000 in your lifetime.

The Intellidex report shows that 73 percent of people with tax-free accounts contributed less than the annual limit in the first two tax years since the accounts were established.

There is a potential problem with opening tax-free accounts with different companies: each company might not know how much you have invested in total, so you need to keep tabs on how much you invest to ensure that you do not exceed the contribution limits.

If you exceed the annual or lifetime contribution limits, the Income Tax Act provides for a stiff once-off penalty tax of 40 percent on any amount you invest in an account above the annual or lifetime contribution limit.

Providers of tax-free savings accounts must report annually to the South African Revenue Service how much you have invested.

‘There are no investment costs.’ A tax-free savings account saves you tax on investment growth, not on investment costs. There are no free investments. All financial institutions that offer investments charge fees, and even savings accounts are not always free of fees. You need to compare the fees on tax-free savings accounts, as you do with any other product.

However, there are two restrictions on the costs of tax-free accounts:

• Providers cannot charge performance fees; and

• Providers can impose a penalty only if you withdraw early from an investment that has a fixed term (see below).

‘You can make a withdrawal only after a specified period.’ The Sanlam survey found that some people believed there were restrictions on the withdrawals you can make from a tax-free savings account. This is not true. One of the advantages of these accounts is that your savings have to be accessible. The regulations governing tax-free savings accounts state that:

• If the investment has no maturity date, you must be able to access your money within seven days of requesting it; and

• If the investment has a maturity date – for example, if you invested with a bank offering a one-year fixed deposit – the investment must be payable to you within 32 days of your request to withdraw.

If the investment has a maturity date and you were guaranteed an interest rate on the investment, such as a fixed deposit earning a particular interest rate each year, you can be charged a penalty if you withdraw early. The penalty is the higher of:

• R300; or

• A value determined by a formula that takes into account the period you have been invested, the amount withdrawn, the years remaining until maturity, and the interest rate you could have earned if you remained invested until maturity.

If the investment has a maturity date, but the returns are not linked to an interest rate, the maximum penalty for an early withdrawal is R500, falling each year to nil over five years.

‘Tax-free savings accounts attract lower interest.’ The Sanlam survey highlighted another common erroneous belief: tax-free savings accounts attract lower interest. In fact, many banks offer their highest rates on savings in tax-free accounts in order to attract new business when these accounts first opened.

In accounts offered by unit trust companies or stockbrokers, the underlying investments and shares earn the same returns as they would outside of a tax-free savings account.

The tax-free nature of the accounts means they should have a higher balance than normal savings or investment accounts. Product providers usually charge fees as a percentage of the assets under management, so they have an incentive to persuade you invest.

‘You can convert an existing investment into a tax-free account.’ This is not strictly true. It is not possible simply to give a new name and tax status to an existing investment. You can, however, transfer an existing investment into a tax-free account, but you will have to sell your existing investment and reinvest R30 000 a year. In the case of non-cash savings, selling your investment could incur CGT. To avoid this tax, make sure you sell investments in such a way that your annual gains realised are within the annual CGT exemption of R40 000.

You will be able to transfer a tax-free savings account from one provider to another from November this year.

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