Former finance minister Pravin Gordhan announced in his Budget Speech in February the introduction of a new top personal income tax bracket where South Africa’s highest earners would pay a marginal tax rate of 45%. This new tax bracket is applicable to all those whose taxable income is R1.5m or more per year. This was one of the many initiatives to generate the R28bn shortfall the fiscus faced.
The effect of this new bracket on a section of taxpayers is to significantly increase their average or effective tax paid. However, while these changes mean less money in taxpayers’ pockets, there are legislated investment products that can reduce this increased tax burden. In fact, the higher taxes move, the greater the tax saving these products offer.
What is an annuity?
The retirement annuity or RA is an often misunderstood and underutilised retirement vehicle. Retirement annuities (RAs) have evolved in their structure over time, with the ones we have today a vastly improved version of what was previously available.
The CFA Institute Research Foundation describes an RA thus: “A company promises to make a series of periodic payments – usually defined as a sequence lasting for life – in exchange for either a large single premium collected at the beginning of the contract’s term or a series of smaller premiums collected before the start of the annuity’s initial payment date.”
Retirement annuity features
RAs offer distinct advantages. The most compelling of these is the aforementioned reduction of your taxable income (up to certain limits). Part of your contributions to the RA comes from tax savings, meaning that Sars is in effect contributing to your retirement savings. An additional benefit is that the growth on your investment is tax-free. A further feature of RAs is that they are in effect “mini trusts”. This means your retirement savings will be protected from your creditors, and can be left as inheritances to beneficiaries, which has estate duty and executor fee savings.
However, RAs also have certain limitations. Your access to your capital is fully restricted until age 55. Regulation 28 also limits your exposure to growth assets (equities and property).
The best way to illustrate the tax benefits of an RA is by means of an example. Thuli Mbete is a political analyst for a major bank and her annual taxable income is R1.85m per annum.
Without any deductions, her tax liability on this income would be R677 490 for the current tax year. This would leave her with take-home pay of R1 172 510. The tax paid means that her effective tax rate is 37%.
However, if Thuli were to utilise her maximum available allowance for an RA of R350 000, this would have a significant impact on her taxable income. The full investment amount of R350 000 could be deducted from her taxable income of R1.85m. In effect, this would lower her taxable income to R1.5m. Thuli’s tax would then be calculated on this lower amount, and would total R519 990, a saving of R157 500 on tax paid for the year. This would translate into a lower average tax rate of 28% for the year. It must however be noted that her take-home pay has decreased by R194?285 to R978 225, but she owns an investment worth R350 000.
What does this mean? In essence, Thuli paid R194 285 for an investment worth R350 000.
One can view this in two ways:
1. Thuli invested R194 285 of her money, and it was boosted by 80.15% to be worth R350 000.
2. Thuli invested R350 000 but received a 44.5% discount on the initial price and only paid R194 285.
By investing in an RA, Thuli Mbete has used her tax saving provided by it to enhance her investment for retirement. This initial boost to her investment can have a significant effect on the future value of the investment. If Thuli had utilised the same investment amount of R194?285 and invested it in another instrument that did not have the pre-tax benefits of an RA, the lack of investment “boost” is significant.
On day one, the RA investment is worth R350 000 compared to the other investment’s R194 285. Assuming a 10% nominal annual growth on both, after 10 years the RA would be worth R993 797 compared to the R503?925 of the non-RA investment. Moving the lens further out, assuming the investor held this single investment for 30 years, the RA investment would be worth R8 012 304 versus R3 390 157 – a 136% gain.
While no investment should be taken without due consideration of your individual requirements, risk tolerance and risk capacity, it is important to understand the options available. In the current environment of heightened market volatility and increased tax burden, an RA could offer a significant positive contribution.
Shutte is the head of investments at The Robert Group,
a private wealth management company.
This article originally appeared in the 4 May edition of finweek. Buy and download the magazine here.