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 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 rate as many individuals’ personal tax rates decrease when they retire.
But wait, there’s even more!
RAs are also advantageous for estate planning purposes. They fall outside of your estate, and when you pass away, the proceeds from your RA will pay out directly to your nominated beneficiaries and there is no estate duty or executor’s fees applicable.
Your money is also mostly protected from the claims of creditors, though there are a few exceptions to the rule, taking into account the Income Tax Act, and any amounts possibly payable under e.g. the Divorce Act and the Maintenance Act.
Investments in RAs are however restricted in terms of Regulation 28 of the Pension Funds Act, which determines the amounts that can be invested in certain asset classes like equities and listed property, and also how much of the investment can be invested offshore, which is currently 25% of the total investment amount.
These innovative new savings vehicles that were launched in 2015 as an incentive by government to encourage savings, offer some of the advantages of RAs, but without the restrictions. They do have some other restrictions though that don’t apply to RAs. Let’s look at these in a bit more detail.
In a nutshell, you are allowed to save up to R30 000 p.a. in a tax-free investment (increasing to R33 000 p.a. in the 2017/18 tax year), up to a lifetime savings limit of R500 000 per individual. Very importantly, any contributions made in excess of these limits will be taxed at a rate of 40% of the total amount exceeding the limits.
This applies to all of the individual tax-free savings investments lumped together that an individual might have, and not individually. Contributions also can’t be replaced, meaning if you make a withdrawal during a year, you can’t put it back. You are only allowed your R30 000 p.a. contribution.
Compared to RAs, tax-free investments offer more flexibility in that the funds are available at any time, you do not have to wait until age 55 before you can access them.
The major benefit of tax-free savings investments is illustrated by the name, all investment growth is tax free, exactly as it applies to the investment growth in an RA. There is no tax on capital gains, interest or dividends. However, the big difference between these products is that the contributions to a tax-free investment are not tax deductible. But one day when you access the funds, no tax will be payable on any of the proceeds either.
Let’s have a look at an example of the impact of tax-free investment growth over different time periods. The following assumptions are made: Lump-sum contribution of R30 000 p.a., invested equally between equity and interest-bearing instruments, with a dividend yield of 3% and an interest rate of 8%. The investment grows at 12% annually.
As seen in Graph 2, the advantages of tax-free investments are only really illustrated over an investment term of longer than 10 years, when the power of compounding can start working its magic. This is an important element of these products that should be considered when deciding to invest in them.
Over a 20-year period, the additional saving is 27% more than the saving for an individual in the 41% tax bracket on a discretionary investment, and 13% more for someone in the 18% tax bracket. However, over a period of 10 years the additional saving is only 12% and 6% respectively.
If you are saving for the short term, rather consider other alternatives and don’t use the R30 000 annual contribution that can’t be replaced for tax-free investments.
So which is best?
If the objective is specifically saving for retirement, an RA is still the best vehicle to use because of the numerous tax advantages it has over a discretionary investment.
Tax-free investments are great for supplementing retirement savings, or other long-term savings objectives like children’s tertiary education (if you start early enough). They also provide flexibility in case of emergency if the funds are needed.
However, each individual’s unique circumstances and time horizon need to be taken into account when deciding how to invest and save for retirement, and this is where good advice is indispensable. Speak to a financial adviser if you are not sure.
Rupert Giessing is a director at Vista Wealth Management, a representative under supervision of Accredinet Financial Solutions.
This article originally appeared in the 2 March edition of finweek. Buy and download the magazine here.