South Africans face major cost pressures, but retirement annuities (RAs) and tax-free investments (TFIs) can offer some respite when the taxman comes knocking.
Allan Gray’s Carla Rossouw said that retirement funds and TFIs can improve one’s chances of retiring comfortably while also offering tax benefits.
However, these products are structured differently, with different product rules and restrictions.
There is also a time element, as tax benefits for the 2023/24 Financial Year are forfeited if one does not make use of them before the end of 29 February 2024.
Rossouw broke down the tax and investment benefits of the two products below:
“RAs offer tax savings now, i.e. you pay less tax now because you make contributions with earnings on which you have not paid tax,” Rossouw said.
“However, you will pay tax when you retire and draw an income (although this will likely be at a lower rate than your current tax rate). Your tax saving now directly correlates with your marginal tax rate; therefore, the higher your marginal tax rate, the greater the tax saving on your RA contributions before retirement.”
One can claim a tax deduction for contributions to an RA to a maximum of either 27.5% of taxable income or R350,000 per tax year.
Although one has less take-home pay, if they increase their RA contributions to enjoy the maximum tax benefit, a smaller amount is going to SARS.
For an individual earning R480,000 per year, the amount of tax they pay decreases as their contribution increases.
If they contribute nothing to an RA, they pay 23% of their monthly salary in tax. However, if they make a 27.5% contribution to an RA, their tax bill drops to around 15%.
Taxpayers can also make a once-off additional contribution to an RA within a tax year, which can be used to ensure that one maintains a certain level of disposable income for the year.
This additional contribution can further decrease one’s taxable income and result in a tax refund.
On top of the tax break on contributions, one pays no tax on the interest, capital gains or dividends you earn while invested.
“Meanwhile, the first R550,000 lump sum you take at retirement is currently tax-free (importantly, this amount includes all previous taxable lump sums received from any other retirement fund or an employer as a severance benefit),” Rossouw said.
“An RA also provides estate duty advantages: When you die, an RA doesn’t form part of your estate, which means it will not attract estate duty.”
“However, excess contributions that have been allowed as a deduction to determine the taxable portion of the cash lump sum benefit on death are included in the value of the property of the deceased for the purposes of determining estate duty.”
Moreover, if one contributes more than the annual limit, their extra, after-tax (non-deductible) contributions (excess contributions) can benefit them over their lifetime, as they will be carried over and deducted in the next year.
However, there are some restrictions on RAs, which some believe outweigh the positives.
Regulation 28 of the Pensions Funds Act limits an investor’s exposure to certain asset classes, with a maximum of 75% exposure to equities and a 45% allocation offshore. These are intended to prevent volatile portfolio performance.
There are also currently liquidity issues as one can only access their funds once they reach retirement, and even then, access to cash is limited.
That said, there will soon be changes with the introduction of the two-pot system, where South Africans will be able to access a maximum of one-third of all retirement contributions prior to retirement.
In addition, those who cease their tax residency in South Africa will only be able to access your RA fund benefits if they have not been a South African tax resident for an uninterrupted time of three years on or after 1 March 2021.
RAs also do not form part of an estate. “Although you are encouraged to nominate beneficiaries to receive your benefit if you die while you are still invested in the product, the trustees of the fund are ultimately responsible for allocating your benefit,” Rossouw said.
Although investors in TFIs use their after-tax money, they pay no tax on the interest, capital gains or dividends they earn or on any withdrawals they make. The main benefit of a TFI is seen over the long term as the tax-free returns compound.
However, there are still restrictions as SARS only allows taxpayers to save a maximum of R36,000 per tax year and R500,000 in their lifetime tax-free, with tax implications for overcontributing.,
Opposed to the excess contribution seen in RAs, one will incur a tax penalty of 40% for any amount over the contribution limits.
“Many investors like TFIs because of their flexibility: Unlike in the case of RAs, there are no asset class restrictions, and you can access your investment at any point in time. However, any amount that you withdraw cannot be contributed,” Rossouw said.
“While your TFI forms part of your estate if it is structured as a life policy, as is the case with the Allan Gray Tax-Free Investment, the investment can be paid to your beneficiaries immediately, and there are no executor fees.”