When it comes to your retirement savings, you’ll want to store your money in the right place. Keeping your money in a fixed savings account with your bank will only lose you money over time, due to inflation. But luckily there are savings and investment accounts that will help you store and grow your wealth over time. So how do you maximize your retirement savings with a Tax-Free Savings Account?
To help you make an educated decision when choosing your retirement account, you’ll need to know the basics of compounding interest and ETF’s. These are the two main factors that will allow you to grow your wealth over time.
What is compounding interest?
Albert Einstein once said that “compounding interest is the 8th wonder of the world.”
Some savings accounts, money market accounts, certificates of deposit (CD’s), and even your credit card work with compounding interest.
Compounding interest is when you earn interest on the principal amount, that you’ve invested, and interest gets added to the new larger principle amount. You’ll be earning interest on interest, which is what leads to exponential growth over time.
For example, if you invested R1 000 in a savings account with 10% year on year interest. You would earn an additional R100 by the end of year 1. Within 10 years you would have more than doubled your investment.
However, if you added an extra R500 per month to your initial investment. You would have had more than R100 000 in just 10 years.
Initial investment: R1 000
Monthly deposit: R500 (R60 000 in 10 years)
Annual interest: 10%
Total investment earnings: R105 000
Total interest earned: R45 000
In the example above, the power of compounding interest increased the total value of the investment by R45 000. That’s R45 000 you’ve been rewarded with because of compounding interest.
What are ETF’s?
An Exchange Trade Fund (ETF) is a type of investment vehicle and typically found in the stock exchange. An ETF is like a basket filled with various companies. So when you invest in an ETF you’re essentially investing in all those companies in that basket. Investing in an ETF is a lot safer than investing in a single company.
But how do you earn money from an ETF?
Like investing in a stock, an ETF makes money through dividends or when you sell your investment for a higher price.
What are dividends?
When you invest your money in the stock market, you’re investing your money with a company. As the company earns profit it distributes some of that profit to its shareholders. That distribution of profit is called dividends.
When investing in the stock market, dividends is what will help you grew your initial investment.
However, not all companies or ETF’s offer dividends. You’ll need to do your research and check which companies offer dividends and what the dividend pay-out would be.
What are capital gains?
Capital gains refers to the profit you’ve made from your investment. However, capital gains is considered a source of income, so you will get taxed. Whether you sell a property or earn money from the stock market, you’ll get taxed on the profit you’ve made.
Now that you have a better idea of how your retirement investment will earn money, let’s look at the different retirement accounts.
Tax-Free Savings Account (TFSA)
Tax-Free Savings Accounts (TFSA) were introduced in 2015 to encourage South Africans to start saving while offering tax relief. All the proceeds from a TFSA, including interest income, capital gains, and dividends are completely tax-free.
You have the option to open two TFSA per year and invest in equities (such as ETF’s), fixed income accounts or both. If you invest your money wisely you can significantly increase your returns over time.
You can only invest up to R36 000 per year, or R500 000 per lifetime.
If you invest more than R36 000 per year you’ll be taxed on the additional money you’ve invested. For example, the annual limited of TFSA is R36 000, if you invest R40 000 throughout the year you would be taxed 40% on the additional R4 000 you’ve invested.
You will not be taxed on the returns you’ve made from your investment. So if you’ve made R2 million from your investment, you won’t be taxed on any of that money. All of that money is for you to spend on your retirement.
Which savings/investment accounts qualify for TFSA?
- Fixed deposits
- Unit trusts
- Retail savings bonds
- Certain endowment policies issues by long-term insurers
- Linked investment products
- Certain Exchange Trade Funds (ETF’s)
For the purpose of this article we’ll focus on fixed deposit and ETF accounts. These investment vehicles are the most popular. They are also the easiest investment types to understand, which make them great if you’re just starting out.
Fixed deposit accounts
Investing your retirement money with a fixed deposit account is a great place to start. Some banks offer TFSA with decent interest rates. But choosing which bank to go with may prove to be tricky. Especially with each bank offering different interest rates and terms. While one bank may offer a great interest rate, while another bank may offer great terms. To ensure you make the right decision, sift through all fixed deposit accounts you’re interested in, and make an informed decision.
Only once you’ve done all your research will you be able to make a great investment decision.
Which SA bank offers the best interest rate on a tax-free savings account?
Generally banks offer better interest rates the more money you push into a deposit account. Banks will offer you a different interest rate depending on the bracket you’re in.
Here are the 2020 TFSA interest rates for all major banks.
You’ll want to ensure that the interest you receive exceeds the inflation rate. The South African inflation rate is currently (2020) sitting at about 4.12%. Although the inflation rate has been on a decline over that past 4 years, it’s still high.
This means that if you invested your money with a bank that offered less than 4.12% interest, you would in fact lose money over time. So ensure that you invest your money with a bank that offers more than the 4.12% inflation rate.
Investing your money with a fixed deposit account should not be your primary strategy. This is a great place to start saving because it’s familiar territory. But this is not a growth strategy. If you want to grow your retirement savings you’ll need to diversify your portfolio. You can do that by investing in ETFs.
Investing in ETFs
When opening a TFSA you have the option to invest in ETFs, which is a great long-term growth strategy.
When deciding on which ETF to invest in you’ll need decide whether you want exposure in the South African market, global markets, or both. You’ll want to be diversified as an investor, so investing in various ETFs may be a great option.
For example, you could invest in the Top 40 ETF (top 40 SA companies) and the S&P 500 (top 500 US companies) at the same time. That way if one of your investments does poorly, the other one may lift your portfolio.
If you had R3 000 per month to invest in your TFSA, you could invest R1 500 in the Top 40 ETF and R1 500 in the S&P 500 ETF.
Good investors keep their portfolios as diverse as possible. You don’t want to keep all your eggs in one basket. To do that, you can invest in various ETFs. For example you can invest in a SA equity ETF, an offshore equity ETF, a property ETF, and a bond ETF. That way you’ll have 4 different assets classes in your portfolio. So if one investment goes down the others will keep your portfolio steady.
How to take full advantage of a TFSA?
If you’re new to investing, start by opening a fixed deposit tax free savings account. Find the bank that offers the best interest rates and fair terms. Deposit as much as you can into this account without going over the limit. While you’re saving your money in a fixed deposit account conduct your own research into ETFs. Give yourself a year to better understand how ETFs work and what you’d like to invest in.
After your first year of saving you’ll have a choice to either move all that savings to ETFs or start investing straight into ETFs from year 2 onwards. You don’t want to keep all your money in a fixed deposit account for a long time. Eventually you’ll lose money. You will have to conduct your own research into ETFs and find the ETFs you’re comfortable investing in.
Avoid putting pressure on yourself to find the perfect ETF. If you choose the wrong ETF you can always change it. Not every investment will be a home run. Have a look at how 9 South African financial experts approached their TFSA. Notice how they all have a different investment approach, some of them even made poor investment decisions.
The most important thing is that you push as much money into your TFSA and start investing in various ETFs as soon as possible.
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