# Saving for retirement as a young person

2012-08-28 20:20

Most of us as young people including the so called educated professionals are stupid.

Do you know why?? It is because we fail to think about tomorrow and plan for the future.

We think that we will forever be young and NEVER grow old. When we get a job we think for today and not necessarily think about what is gonna happen tomorrow when we are 65.

When you get a job at 25 years, the sooner you start saving for old age.  What guarantee do you have that the lifestyle you are living today at 25 will be the same when you turn 65? You need to maintain your standard of living when you grow old and cant work anymore.

By starting early with your saving for retirement and not delaying your savings, you can considerably enhance the amount you have available to spend in retirement.

Let me use an example to illustrate the point.

Thabo and Sizwe are both 25 years old when they begin working. Thabo earns R9 000 a month while Sizwe earns R15 000 a month.

During his first month at work Thabo decides to begin investing R1 000 a month as part of his saving for retirement plan.
Sizwe, however, wants to wait until he is older to begin saving as he wants to get a new car and live a comfortable life without using taxis.

Assuming a real rate of return of 8%, by the time Thabo is 40 he would have accumulated approximately R380 000.

It is at this point that Sizwe (40 years) decides to start saving for retirement because he now feels he is ready and can afford to start saving.

Sizwe realises that he needs to start saving aggressively to achieve his retirement goals and decides to invest R1 600 a month (60% more than Thabo saves each month). He achieves the same real rate of return of 8%.

Both retire (and terminate their monthly contributions) at age 65. At this point Sizwe and Thabo have contributed R480 000 towards their retirement by way of monthly contributions.

Now comes an astonishing point: Thabo’s R480 000 contribution has grown to R3,5 m (YES MILLION) while Sizwe’s R480 000 contribution has only grown to R1,6 m. The huge difference between Thabo’s and Sizwe’s retirement nest eggs can be attributed to compound interest.

Compounding is the effect of earning interest on interest. The phenomenon of compound interest is a potent force and can make a huge difference in growing your money. In Thabo and Sizwe’s case it was the difference between a modest retirement and comfortable retirement. Therefore Thabo can afford to maintain his lifestyle even though he is no longer working.

There are 3 main Retirement Planning Vehicles on the market currently, namely Pension fund, Provident Fund and Retirement Annuity.

I will try and explain each of them as best as I can with their pros and cons and how YOU can benefit from each of them to fix your lifestyle.

The pension fund is meant to generate stable growth over the long term, and provide pensions for you when you reach the end of your working years and commence retirement. Generally, YOU and your employer will contribute to this depending on your package and contract with the company.

There could be a membership agreement between employer/employee and your employer can contribute for you.

·         How do you get the money???

Maximum of one third may be taken as a lump sum. The remainder must be used to purchase an annuity.  For example if your TOTAL PENSION FUND is R3m. You will get R1million in as a cash payout then R2million will be paid as a pension for the rest of your life.

·         Tax Treatment??

Tax deductible is subject to a maximum of the greater of:

1. 7.5% of retirement funding income
2. R1 750

Meaning you will get a tax benefit if you contribute towards a pension fund.

·         Tax treatment of lump sum on retirement (or death)??

The sad news is that SARS will tax you when you get paid out this money. The beauty about a pension fund, is under the new rules R300 000 is exempt from tax on retirement. But if you have saved up R3million for example SARS will tax you at a rate of R135 000 plus 36% of taxable income exceeding R900 000.

·         Flexibility of withdrawal of benefits before retirement??

The disadvantage of a Pension Fund is that you may only withdraw at termination of services or disability. If you choose to withdraw your savings before retirement you will be taxed at a higher rate, therefore there is a penalty in way.

Now let us move on to a PROVIDENT FUND:

A provident fund is established for the purpose of providing benefits for you by your employer on retirement, or your dependents.

There could be a membership agreement between employer/employee and your employer can contribute for you.

·         How do you get the money???

Under a provident fund, the full amount of the benefit available at retirement may be taken as a lump sum cash payment, irrespective of whether the benefit is calculated on a defined benefit or a defined contribution basis. For example if you have saved up R3million you have the option to take that R3m all at once.

·         Tax Treatment??

There is no tax deduction, meaning there is no tax benefit for you when you contribute on a monthly basis.

·         Tax treatment of lump sum on retirement (or death)??

Under the new SARS rules R300 000 is exempt from tax on retirement. But if you have saved up R3million for example SARS will tax you at a rate of R135 000 plus 36% of taxable income exceeding R900 000.

·         Flexibility of withdrawal of benefits before retirement??

You may only withdraw at termination of services or disability.

Now let us move on to the last one which is the RETIREMENT ANNUITY FUND:

A retirement annuity fund provides life annuities (income/allowance) to the members of the fund, or their dependents or nominees of deceased employees at retirement.

There is no membership agreement between employer/employee required and your employer may not contribute for you.  So you can do this independently on your own. You just need to find the right retirement annuity company to facilitate this for you.

·         How do you get the money??

The maximum of one third may be taken as a lump sum. The remainder must be used to purchase an annuity.  Like the Pension Fund for example, if your TOTAL RETIREMENT FUND is R3m. You will get R1million in as a cash payout then R2million will be paid as a pension for the rest of your life.

·         Tax Treatment??

Tax deductible subject to a maximum of the greater of:

1. 15% of taxable income from non retirement funding income
2. R3 500 less your current pension fund contributions or
3. R1 750

In simple terms, you will get a tax benefit for your monthly contributions.

·         Tax treatment of lump sum on retirement (or death)

Lump sum is taxed at your marginal rate at the time of retirement less R1 800 (less previous contributions that were disallowed for tax purposes)

·         Flexibility of withdrawal of benefits before retirement??

Yes, you may only withdraw before retirement. But the following conditions need to met:
- On death or disability or age 55
- If amount is less than R7 000
- On emigration (subject to exchange control)

Now you might be wondering which one is the best out of these 3 products:

For me personally I feel that Retirement Annuities were designed for people with a high income. Retirement Annuities do offer a number of advantages. They are seen as a good way to enforce self-discipline to save for retirement. Typically, Retirement Annuities have been favoured by investors with higher incomes who have sought to use the tax deductibility of contributions to Retirement Annuities to lower their immediate tax liability.

In principle, investors in a Retirement Annuity are obtaining a tax benefit on a relatively small invested amount. This amount should grow considerably, and the resulting annuity (conceivably a greater amount) will be subject to income tax.

You can have a pension fund and a retirement annuity at the same time. But I am very doubtful about the real tax benefits of Retirement Annuities.

If you want to have a Retirement Annuity rather start with an amount that is more likely to be sustainable in the long term than overdo it from the start and risk lapsing policies because you were too optimistic.

You may not withdraw from a Retirement Annuity before reaching the age of 55 and with some of the traditional products, you are bound to a contractual term and harsh penalties are levied (up to 15% of the value of your investments) if you stop or decrease your premiums.

Therefore I would advise against having a Retirement Annuity if you don’t have a pension fund and are a low income earner. Hence I say it was designed for high income earners.  A pension fund is a company run pension scheme. A retirement annuity is a "pension scheme" for individuals.

With a company pension fund the employers contribute on behalf of each member, which often matches or exceeds that of the member. This contribution usually covers all the expenses of the pension fund except for the fund management costs, and the balance is invested on the member’s behalf.

Pension funds offer better tax benefits to you personally. Your contributions to a pension fund are deductible for tax, while contributions to a provident fund are not.

The strongest argument in favour of provident funds and the lump sum payment concerns the means test used to work out whether a person qualifies for a state old-age pension. Usually if you receive a private pension, you are automatically disqualified from receiving a state old-age pension. But if you get a lump sum payment then that you can also qualify for a state pension in some cases.

But my issue with a provident fund is that when you change companies at times you have the option to get a pay out of your provident fund.  To me, that is a waste of money as you will just make the tax-man (SARS) happy. NEVER CASH IN on your provident fund. But people often do to their detriment.

The provident fund is usually more flexible than the pension fund. Part of the lump sum can be used to buy a private pension through a private pension company. The main advantage of a pension fund is that it is paid for life. The pension will be paid out until you die. This offers you security because a certain amount of money will be coming in every month. If you are not disciplined to deal with a large sum of money, then it is better to get the money paid out in small amounts every month.

If you are high income earner you can mix pension fund and a retirement annuity together at the same time and reap the tax rewards. But it makes no sense to take out a retirement annuity on its own as you are not reaping the tax benefits as you would with a pension fund and are a low income earner.

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