Diversify savings and benefit
Making sure that you are saving enough for a financially secure retirement is crucial, but Danie Venter, a certified financial planner and advisory partner at Citadel Investment Services, warns that many investors fall prey to the common financial mistake of overcontributing towards their retirement funds.
The South African Revenue Service (SARS) allows tax deductions for contributions to a pension fund, provident fund or retirement annuity up to the value of 27.5% of the greater of your taxable income or remuneration. This deduction is also limited to an annual ceiling of R350,000.
“This represents a generous tax incentive to increase your retirement savings, but your investment strategy should also take into consideration your tax consequences after retirement,” says Venter.
To demonstrate the benefit of having a savings mix, he offers the example of a 44year-old investor named Richard, who earns R62,500 each month or R750,000 per annum. Having lived frugally and saved faithfully from his first pay cheque, Richard has R2m in his retirement savings pot and is free of other debt.
Venter then compares two scenarios based on Richard’s decision to focus solely on retirement savings, or opt to additionally build up a discretionary savings portfolio.
In scenario one, Richard, wishing to retire at 65, increases his retirement fund contributions to 27.5% of his salary, or R17,187 each month, amounting to R206,250 every year. Without retirement savings, Richard’s total tax liability would equate to R212,490. Implementing the 27.5% contribution would then mean a tax saving of R81,000 every year, leaving him with a net annual income of R412,175.
Assuming that his contributions increase by 6% each year in line with inflation, and that his retirement portfolio delivers returns of 8.5% per annum net of fees, his retirement savings would ultimately be worth a princely R8.9m in today’s value.
Richard next decides to withdraw the full one-third portion of his retirement savings allowed at retirement, amounting to just under R3m. As the first R500,000 of the amount withdrawn from your savings is tax free, Richard would pay R822,349 in tax on this withdrawal or 27.6%
He invests the remaining R2.15m in a discretionary investment portfolio and R5.95m remains in his retirement savings, which he uses to purchase a living annuity. He selects a 7.5% drawdown level from both his discretionary and retirement savings for income.
Future withdrawals from his discretionary savings will be subject to capital gains tax (CGT), which is capped at an effective tax rate of 18% for individuals and has an annual capital gains exclusion of R40,000 per annum. The income from his retirement savings on the other hand will be subject to income tax which could accumulate to a marginal rate of 45%.
By comparison, had Richard invested his savings in a living annuity instead of withdrawing a one-third portion to invest in discretionary savings, he would need to withdraw nearly a third more from his living annuity each year to achieve a similar income, or at least R690,000 per annum. Which would then be subject to an effective tax rate of 26.2%, meaning that he would also be paying R70,000 more in tax each year than if he had invested a portion in discretionary savings.
In scenario two, before deciding how best to save towards his retirement Richard consults a financial adviser, who advises him to consider implementing a discretionary savings portfolio in addition to his retirement savings.
Instead of investing the full 27.5% tax deductible portion of his salary into retirement savings, Richard opts to contribute 15% of his salary or R9,375 every month to his retirement savings. His net annual income after tax would change to R469,718, instead of R412,175 where he maximises his retirement savings contribution (27.5%). Instead of spending this difference of R57,543 he invest this in a discretionary savings portfolio.
Assuming he again increases his contributions in line with inflation of 6% every year, and he achieves the same 8.5% return net of fees, at the age of 65 Richard would have R6.4m in his retirement savings and R1.7m in discretionary savings. The discretionary savings is then bolstered by withdrawing R1.37m from his retirement savings, paying only R247,500 in tax. He then invests the R5m remaining in his retirement savings in a living annuity.
To achieve a similar annual income of more than R500,000 as in the first scenario, he would need to withdraw as little as R372,875 or 7.5% from his retirement savings a year, and supplement his income by withdrawing just under R223,948 (8%) from his discretionary savings. Resulting in a tax saving of R100,000 in comparison to exclusively contributing towards retirement savings.
Venter emphasises the need for flexibility in building your investment portfolio, pointing out a range of additional benefits to ensuring you have a savings mix.