Does the taxman help you save for retirement?
Tax-free savings products were introduced two years ago while retirement annuities – in some form or another – have been around for decades. How do they measure up in terms of helping you to save for your golden years?
with the end of the tax year on 28 February, now is a good time to remind ourselves again of the numerous advantages of saving for retirement through certain investment products. These investment vehicles have considerable tax advantages over discretionary products, where these benefits do not apply.
Specifically, we’ll be looking at the good old retirement annuity and then also tax-free investments, which were introduced in 2015 as an additional savings vehicle to encourage South Africans to save more.
Retirement annuities (RAs)
RAs have been around for as long as most of us can remember. They are basically private pension plans, specifically designed to help you save for retirement. They have evolved significantly over time into much more flexible and affordable investment vehicles from the more traditional life insurance products of old.
Investors can now make use of so-called “new-generation” RAs on linked investments platforms (LISPs). These are more flexible and far less expensive to administer, contributions can be made as and when the investor chooses (in the form of a lump sum or a regular debit order) without possibly paying any penalties for missing contributions, and there are also a wealth of underlying unit trusts available to choose from.
Benefits of saving through an RA
The first and most significant benefit is the tax deductibility of RA contributions. As from 1 March 2016 all contributions to pension, provident and RA funds are consolidated and are deductible up to 27.5% of the greater of remuneration or taxable income, capped to R350 000 annually.
Graph 1 on page 23 gives an indication of the amount an investor can expect to receive as an annual refund, based on a specific annual income. (Assuming an annual contribution rate of 15% of remuneration.)
But don’t go and spend that RA rebate, it can considerably boost your retirement benefit. If we look at a practical example using an individual who earns an annual salary of R600 000, increasing at 6% per annum, who starts contributing to an RA at age 40, for a period of 25 years, the annual refund will be R33 897.
The monthly RA contribution at a rate of 15% per annum amounts to R7 500. Assuming no change in tax brackets for purposes of slightly simplifying the calculation, an annual investment growth rate of 10%, inflation rate of 6% and if the individual then also reinvests the annual refund from year 1 for a period of 24 years, the individual would have saved an additional R 2 864 031 (total proceeds of R11 549 735) at retirement.
To put the numbers in perspective, it’s an increase in retirement savings of 33% at age 65!
RAs also offer other tax advantages
The benefits of saving through an RA don’t end there. With any discretionary investment, capital gains tax is payable; not so with an RA. Interest and dividends are also not taxed in an RA, which means basically all investment growth is tax free, and this also adds up exponentially over the long term. We will have a closer look at an example of the impact of tax-free investment growth when we discuss tax-free investments further down in this article.
But, what the taxman giveth, the taxman will eventually taketh away. When you put up your feet one day when you retire, you will have to pay tax on the proceeds taken in cash (you are allowed to take up to one third in cash at retirement, any time after age 55). However, lump-sum benefits are taxed on a favourable sliding scale with a portion of the benefit tax free. Because you are deferring paying tax on the proceeds of your RA, there’s also a larger investment amount that can grow and compound over time, all tax free.
The other two thirds of the proceeds from your RA will be used to purchase an annuity, which will then be used to provide you with an income during retirement. You will have to pay tax on your monthly “income” but once again, it will most probably be at a lower