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Tuesday 28 July 2020

Could The Tax Penalty For Exceeding Your TFSA Limits Be Worth It?

Is it possible to score from a TFSA
Those of you with TFSA accounts should be familiar with the annual and lifetime limits which apply. As it stands, there are severe penalties for contributing more than R36,000 to your TFSA in a single tax year, and more than R500,000 over your lifetime.

In other words, you are allowed to exceed the limits, but SARS will bring out their big, 40% stick.

That means any money you contribute to a TFSA which exceeds the annual or lifetime limits, will be liable for 40% tax. i.e. if you contribute R40k in a year, you will pay 40% of R4,000 = R1,600 in tax.

If you contribute R600,000, it's R100,000 over the lifetime limit, so you will pay 40% of R100,000 = R40,000 in tax.

I think you get the idea.

On the other hand, there are some really great tax benefits inside of a TFSA. SARS won’t charge you any dividends withholding tax, income tax, or capital gains tax on any money inside of a TFSA. And when you view this great perk of a TFSA in light of the over-contribution penalty, it makes for an interesting dilemma...

Is it worth it to take the upfront tax hit to score on the tax benefits inside the TFSA?

Of course, practically, you may not be able to exceed your annual limit (some TFSA providers stop you from contributing more than the annual limit to protect investors from accidentally over-contributing), but let’s assume you found a TFSA provider that would allow you to it.

Let’s also assume someone had not made any TFSA contributions and they just so happened to have the TFSA lifetime limit of R500,000 lying around waiting to be invested.

Would the tax penalty from contributing the entire R500k in a single year, be offset by the tax benefit of having the money inside a TFSA?

It’s an interesting question, and it may also solve for the complaints that many older investors have around not being able to maximise the lifetime limit of their TFSA because they have less than 14 years of employment left (at R36,000 a year, it will take you around 14 years to hit the current lifetime limit).

Okay let's check this out by running 2 scenarios. Someone with R500,000 to invest could either:
  1. Dump it all into a TFSA, take the tax hit, and let it run inside the TFSA without making any further contributions. Or,
  2. Phase the money into a TFSA at R36,000/year until the lifetime limit is reached.
Let’s assume that in both cases, this person’s TFSA is invested in a diversified, equity heavy portfolio which generates 12% per annum.

If this person dumps the entire R500k in, it means they will exceed the R36,000 limit for that year by R464,000. This means they will be taxed at 40% of R464,000 = R185,600 (ouch!). Let’s also assume that they pay this tax hit upfront.

All this means that a total of R314,400 lands in the TFSA account. Let's check how that plays out versus a R36,000 per year contribution over 14 years (click for a larger image).

At the end of 14 years, the investment balance of dropping the R500k in and paying the tax penalty is R1,536,508.

This compares to phasing the money in R36k at a time, which leaves you with an investment balance of R1,301,589.

So throwing it all in and taking the tax hit leaves you around R235k better off – seems like a great idea right?

Not yet - there are still 2 more factors to consider...

Firstly, it might be possible to pay the tax hit from outside of your TFSA account – i.e. you can make sure that the full R500k hits your TFSA account (and not just R314,400). In order to do that you would need R500k plus an extra R185,600 to cover the tax bill – a total of R685,600.

And then there’s something else we overlooked in the previous scenario...

If you did have the lumpsum available to phase into a TFSA, you would add the R36k a year, but it’s unlikely that the rest of the money would just be sitting idle. No, it would probably already be invested somewhere else earning a return while it waited to be transferred into a TFSA. Not so?

So let’s assume the remaining money is invested in a similar asset allocation as the TFSA. Again we assume a 12% return, except, this time it is subject to all those delightful taxes you need to pay outside of a TFSA - Dividends Withholding Tax, Income Tax etc.

Dividends Withholding Tax is a flat 20%, and let’s assume the portfolio’s returns include 2% from dividends. 20% of 2% means that the returns loose 0.4% per annum to dividend tax. Income tax is a little more tricky to account for since that will depend on your marginal rate and how much of your portfolio is in REITs. So let’s estimate it adds another 0.4% drag on returns. This leaves a total of 0.8% per annum lost to tax - i.e. the non-TFSA money earns 11.2% per annum.

So now the two scenarios are:
  1. Take a lumpsum and invest R500k into a TFSA at once, pay the tax hit of R185,600 for a total investment cost of R685,600. Or,
  2. Phase a lumpsum of R685,600 into a TFSA 36k at a time, while the rest stays invested in a discretionary account earning 11.5% per annum.
Here's what it looks like over 14 years (click for a largerimage).

Leaving the rest of the money invested now makes the tax penalty option pretty painful! Phasing the money in leaves you with R3,109,685 versus the R2,443,556 you get after dropping it all in and paying the tax penalty. That's leaves you around R666k (ominous!) better off by phasing it in.

Okay, so that covers the scenario up to 14 years, at which point the TFSA has been maxed. But what about running it for longer, does the benefit of being in a TFSA kick in then?

Well I extended the scenario to 100 years, and still, taking the tax penalty leaves you worse off. You just cannot recover from that 40% hit!

And then finally, there is still maybe one more benefit of a TFSA which I have not considered - the fact that there is zero CGT payable in a TFSA when you sell.

Now it is highly unlikely that someone will just up and sell their entire TFSA at once (it's far more likely that they'll sell off portions annually once they hit retirement) . But let's assume they want to sell it all. Let's also assume that they pay the highest CGT rate - 18%.

How does the tax hit versus phasing it in numbers look now?

After 14 years:
Lumpsum with tax hit - R2,443,556 (i.e. still the same, no CGT payable in a TFSA)
Phasing it in, CGT payable on discretionary investment - R2,784,228

So it's still better to phase it in.

And what about longer time frames?

Well, after 26 years or more, if you consider the CGT implication of selling the entire investment, you will be better off by taking the tax hit instead of phasing it in.

So does that make it worth incurring the tax penalty?

In my view - no! 
(Unless you plan on investing it for over 26 years and you going to sell the entire investment and you will be bringing in more than R1,577,300 per annum in retirement (making you a 18% CGT kind of earner.))

Till next time, Stay Stealthy!
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