Reason for saving
If you are looking to save for retirement, you have two basic options:
Pension and Provident Funds: Pension and provident funds are sometimes also called umbrella funds. If your employer deducts retirement contributions from your salary before tax then you are invested in either a pension or provident fund.
Retirement Annuities (RAs): This product allows a person (in their individual capacity) to save for retirement in much the same way that they would through an employer sponsored pension fund.
The most significant attraction of pension and provident funds, as well as RAs, is that earnings on investments are tax free. It is also a significant advantage to some that these products, if purchased through a life insurer, can offer access to funds with underlying investment guarantees.
Currently, with an employer sponsored pension or provident fund it is possible for your contributions to be tax deductible up to 27.5% of your income. With an RA this tax deductibility is normally limited to 15%, but may be higher under special circumstances. Part of the legislation promulgated by the National Treasury aims to align pension funds, provident funds and RAs so that they are more or less equivalent and so this tax difference is soon to be a thing of the past.
In all retirement wrappers, investment choice is restricted by law. For example, any fund in which you are invested may hold a maximum of 75% equity. Most importantly, the purchase of a retirement product automatically restricts access to your funds, which cannot, except under exceptional circumstances, be withdrawn before age 55.
Even once you do gain access, for both pension funds and RA’s only one third of the total amount saved may be taken as cash, with the remaining two thirds (as a minimum) required to be used to purchase a post-retirement product that will pay an income to you in your retirement. With provident funds, 100% of the proceeds may be taken as cash, but National Treasury is likely to change this in the near future so that Provident Funds are aligned with the working of RA’s and pension funds.
When it comes to costs, employer sponsored retirement funds are almost always going to be the cheapest way to save for retirement. Therefore, when saving for retirement, if you have this option you should take it. The main downside is that they might offer a very restricted investment fund choice. If you feel that the funds available are really not right for you, then it would be justifiable to purchase an RA, where you have a little more flexibility and control, but this will be at a cost.
The basic premise that saving pays is valid no matter how you choose to save your money.
We may assess the value of each of the major savings vehicles detailed above based on answers to the following questions:
Length of time you plan to save for
We may start by dividing savings products into two basic categories because no matter where you choose to save your money, you are effectively saving either with your bank or with an investment linked product. While this initial decision is important, it is actually an easy one to make because saving with your bank (in fixed deposit or 32-day call accounts, for example), while fairly straightforward to do, is only a good idea over the short term. This is because (after adjusting for inflation) your money isn’t really growing in the bank, but it is very safe. Saving in a bank savings product is also a good idea for those funds you want to put away for use in an emergency.
If you’re looking to save over the medium to long term, it is a good idea to invest in investment funds through an investment linked product. This is because, with the appropriate investment strategy, over time, the investment returns you should earn should handsomely outstrip the returns that a bank’s savings product could offer.
Investment funds (sometimes called unit trusts, collective investment schemes or mutual funds) are pools of investors’ money used to buy equity, property, cash or bonds, either locally or internationally, on behalf of those investors. Of course any individual is able to buy and sell the same assets in a personal capacity. But a lack of knowledge, skill and experience and a relatively low buying power are among the very good reasons that this is, for most of us, a bad idea. Instead, we can invest in a fund, managed by professionals.
Getting your money into an investment fund that suits your savings plan can be done in a number of ways, and the best way for you will mostly depend on your individual tax situation – which leads us to the next consideration.
Your individual tax situation
Being taxed in your own hands means that all investment returns you earn will be taxed in your individual capacity. The tax rules in your individual hands are fairly complex, but essentially you are exempt from a specified amount of interest and capital gains. Returns beyond this amount are then taxed at your marginal income tax rate, after an adjustment to the capital gain returns.
The alternative is to be taxed in the hands of a company, and this is done by using a tax wrapper called an endowment. Within an endowment the investment returns are taxed at 30% within the product, and the total amount you receive is then tax free in your hands.
Unless you are both a high income earner, with a marginal tax rate comfortably in excess of 30%, and an investor who is likely to earn significant investment returns, you are better off being taxed in your own hands. In fact if this is not the case, an endowment will likely result in you effectively paying more tax than you should.
For this reason, most of us should opt to either save directly in an investment fund, or through a platform called a Linked Investment Service Provider (Lisp).
Investing Direct: This means contacting a fund manager directly and investing a certain amount of money in that fund. The most attractive things about going direct are relatively low fees.
Investing through a Lisp: Investing in a fund through a Lisp is very similar to going direct. A Lisp is essentially a platform that makes available funds from an array of asset managers. Since they pool large amounts of money and have access to institutional rates, the costs of investment through a Lisp are often almost as low as they would be investing direct.
The added attraction for the individual is that it is easier to diversify your investments through a Lisp and easier to manage your investment portfolio, since you are only dealing with a single provider while potentially investing across a number of asset managers.
As discussed earlier, if you have a high marginal income tax rate and already make use of the bulk of your investment return tax exemptions, then an endowment is likely to be the best way to save.
Endowments: An endowment is likely to present a very similar investment fund choice to that offered by a Lisp. But this product has two notable advantages. Firstly, an endowment sometimes offers the investor access to funds with investment guarantees. These guarantees may come in various forms, but essentially they ensure a certain level of performance on your investment.
Secondly, investment returns on an endowment are taxed at 30% - something that is potentially attractive to the very wealthy. Of course, for anyone whose marginal tax rate is less that 30%, this feature of an endowment is in fact a disadvantage. Furthermore, this tax arrangement is only valid if money is invested in an endowment for more than five years.
In addition to those discussed above there will be a new savings product available from March 1 2015, with its own set of tax rules. It aims to be attractive to the average saver and we will describe what we know about this product in a forthcoming article.
The FutureGuide Savings, Investment Cost and Retirement Savings calculators are useful tools that can help you to develop an effective savings plan no matter what your goals.
* This guest post was submitted by FutureGuide, which provides free financial tools and information to help people make the most of their money.
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