Mix of savings ‘a better way to save for retirement’

Contributing 27.5% of your income to your retirement fund gives you a generous tax break now, but have you considered the tax implications when you draw an income in retirement? Here is the case for using both a retirement fund and discretionary investmen

WITH higher tax rates on the cards this year, you may be looking at making the most of the tax break on contributions to your retirement fund. But the numbers suggest that tax efficiency and achieving the best-possible income in your golden years could require finding a balance between your discretionary savings and your retirement fund.

Danie Venter, a Certified Financial Planner and an advisory partner at Citadel Investment Services, says it is crucial that you are saving enough for a financially secure retirement, but he warns that many investors make the mistake of over-contributing to their retirement funds.

The South African Revenue Service allows you to claim a tax deduction of up to 27.5% of the greater of your taxable income or remuneration on contributions to a pension fund, provident fund or retirement annuity fund. The deduction is capped at R350 000 a year.

“This represents a generous incentive to increase your retirement savings, but remember that your investment strategy should also take into consideration the tax consequences in retirement,” Venter says.

“It’s also worth noting that, while contributions above these limits will be added to the tax-free portion of your withdrawal allowance at retirement, these contributions are not adjusted for inflation, losing their value in real terms.”

To demonstrate the benefit of using a retirement fund and discretionary investments, Venter uses the example of a 44-year-old investor named Richard who earns R62 500 a month, or R750 000 a year. Having lived frugally and saved faithfully from his first payslip, Richard has R2 million in his retirement savings pot and is debt-free.

Venter compares two scenarios, one in which Richard contributes solely to a retirement fund, and the other in which he also builds up a discretionary portfolio.

Scenario 1: Saves 27.5% in a retirement fund

Wanting to retire at 65, Richard increases the contributions to his retirement fund to 27.5% of his salary, or R17 187 a month, or R206 250 a year.

If he did not contribute to his retirement fund, Richard’s total tax liability would be R212 490. Contributing 27.5% to his retirement fund results in a tax saving of R81 000 a year, leaving him with a net annual income of R412 175.

Assuming that he increases his contributions by 6% a year, in line with inflation, and that his retirement portfolio earns a return of 8.5% a year net of fees, at 65 Richard would have accumulated retirement savings of R8.9m in today’s rands.

At retirement, Richard withdraws the full one-third cash lump sum from his retirement savings, or just under R3m. The first R500 000 of the withdrawal is tax-free, so Richard pays tax of R822 349, or 27.6%, on this amount.

Of the balance, Richard invests R2.15m in a discretionary investment portfolio and uses R5.95m to buy a living annuity. He selects an income drawdown level of 7.5% from both his discretionary investments and his living annuity.

Withdrawals from his discretionary investment portfolio will be subject to capital gains tax (CGT), which is capped at an effective tax rate of 18% for individuals. There is an annual capital gains exclusion of R40 000.

On the other hand, the income from his living annuity will be subject to income tax, and the top marginal rate is as high as 45% (see Table 1, below).

By comparison, if Richard invests all his retirement savings in a living annuity, instead of withdrawing one-third to invest in discretionary savings, he will need to withdraw nearly a third more from his living annuity each year to achieve a similar income, or at least R690 000 a year. This income will be subject to an effective tax rate of 26.2%, which means that Richard will pay R70 000 more in tax each year than he would if he had invested a portion of his retirement savings in a discretionary portfolio (see Table 2).

Scenario 2: Saves 15% in a retirement fund and the balance in a discretionary portfolio

Before deciding how best to save for retirement, Richard consults a financial adviser, who advises him to consider investing in a discretionary savings portfolio in addition to his retirement fund.

Instead of investing the full 27.5% tax-deductible portion of his salary in a retirement fund, Richard contributes 15% of his salary, or R9 375 a month, to his retirement fund. His net annual income after tax is therefore R469 718, instead of R412 175, as in Scenario 1.

Instead of spending the difference of R57 543, Richard invests the money in a discretionary savings portfolio.

Assuming that Richard increases his contributions in line with inflation of 6% every year, and that he achieves the same 8.5% return net of fees, at 65 Richard will have R6.4m in his retirement fund and R1.7m in discretionary savings.

At retirement, Richard boosts his discretionary savings by withdrawing R1.37m from his retirement fund, paying only R247 500 in tax. He uses the remaining R5m to a buy a living annuity.

To achieve an annual income of over R500 000, as in Scenario 1, Richard will have to withdraw as little as R372 875, or 7.5%, from his retirement fund and just under R223 948, or 8%, from his discretionary savings.

The result of this approach, as opposed to contributing exclusively to a retirement fund, is a tax saving of R100 000 (see Table 3).

OTHER BENEFITS

Venter says there are other benefits to using both a retirement fund and discretionary investments.

For example, unlike retirement funds, discretionary investments are not restricted with respect to where they can invest. For example, retirement-saving vehicles can invest a maximum of 25% offshore, whereas discretionary savings can invest fully offshore, allowing for protection against a volatile rand.

“Also remember that, once your retirement funds are converted into retirement income (or a pension), ‘emigrating’ with the funds will not be possible, as, even if you decide to emigrate from South Africa, your income would first have to be paid into a South African bank account.

“The wisest course of action is to consult a professional financial adviser, to help you develop a longterm financial strategy tailored to your unique situation. This will help you to achieve the best outcome, while maintaining flexibility,” Venter says.