A Tax-Free Savings Account (TFSA) offers a superb, tax-efficient mechanism to compound long-term investments for South African citizens.
In the below example, I use an assumption of 15% CAGR per annum from a basic South African equity investment and assume that you are paying a marginal tax rate of 45%. I also assume the effective capital gains tax rate is 18%, but in reality, it will probably be higher in the future (Governments tend to hike taxes on rich, especially in countries like South Africa).
Just these basic variables stretched out over 30 years of investment horizon reveal the massive difference between an equity investment made via a TFSA and the same one made in your own name: And the difference is only the tax paid.
Said different, the (legal) avoidance of tax is free upside to you as the investor. And, in the TFSA, the greater risk you take and the longer time period you leave it, the greater the compounding and upside potential and the greater the tax bill you do not have to pay.
Hence, the greater the free upside you gain.
Due to this, I am of the opinion that any astute investor in South Africa should strongly consider making a small cap equity investment fund their core underlying for their TFSA.
In the long-term, small caps outperform large caps (see below figure). Thus, while equity is a great underlying in a TFSA for those with 20+ years to invest, the best underlying is, in fact, the fastest-growing (albeit riskiest) part of the equity markets: small cap equities.
I think the greatest tragedy is when people do not take advantage of the TFSA mechanism. The second greatest tragedy is when banks or other enterprises convince them to invest their TFSA in some low-interest, capital-eating account for the next couple decades.
The TFSA is for sticky, long-term money that should be agnostic as to the cycle or inherent short-term volatility of the underlying. The TFSA is for taking risk over long periods of time.
Don’t sell yourself short here; buy risk and sell time. Invest in small caps via your TFSA!
OK, marketing aside, I really do believe this. At least, consider taking some risk with your TFSA? In the long-term, the greatest risk you can take is no risk at all.
P.S. Below is a chart of S&P 500 Index (converted into ZAR) versus the FTSE/JSE Small Cap Index (also, naturally, in ZAR). Our local small caps do not just beat the “safe” offshore large cap index (including Rand depreciation!), but they completely smash it out of the park. Data is for the entire available period I could get.