Financial Planning

The retirement annuity tax myth busted

I’m sure many of you have noticed how we associate nearly every month of the year with something. September is the month of spring, while December brings about the smell of the sea and suntan lotion, accompanied by Boney M in almost every single mall you visit. February brings about tax season, or to some, Retirement Annuity (RA) season. It is called RA season because this is the month during which investors have to contribute as much as possible to their retirement annuities to ensure that they can still reap the tax benefits before the tax year comes to a close on the last day of February.

At this point, I want investors to take note that most RA providers can only accept contributions for the current tax year up to between 3 and 5 days before the end of February, to ensure that your funds reflect in your investment in time. That means that by the time you read this article and you realise that you would still like to make a contribution, you need to get the ball rolling immediately.
Over the next few weeks, I would like to show investors how to make the most of this product, by mainly focusing on how to build a share portfolio in your RA. But before I get to the “what I should put in my RA” part of things, I would like to discuss one of the biggest myths surrounding RA’s: the belief that you don’t need to make the most of the tax benefits associated with an RA before retirement, as you will pay tax on your income anyway after retirement. My response to this is short: You couldn’t be more wrong.

Let me explain by using the table below as a starting point (Old Mutual tax calculator salary table), and more specifically, the taxes paid by South Africans in various salary classes (provided that they make no other contributions to a pension/retirement fund, and excluding medical aid deductions). This shows us that a person that currently earns R50 000 per month has to pay R12 595 monthly in taxes according to the current income tax legislation, leaving him with a net monthly income of R37 405pm.

Table 1: Income tax levied on different monthly salaries, with and without RA contributions (source: Old mutual Income Tax Calculator & PSG Wealth Old Oak)

I will discuss the characteristics of an RA and the maximum tax-beneficial contributions (up to 27.5% of the greater of remuneration or taxable income, with an annual limit of R350 000) you can make annually at a later stage. For the purpose of this column, however, I would like to use a 15% contribution of an investor’s taxable monthly income as an example. By getting back to the person who earns R50 000pm, that would mean that at 15%, his contribution would amount to a R7 500pm saving in an RA, while only being taxed on the remaining R42 500 of his monthly income, which, in turn, means a decrease in monthly income tax from R12 595pm to R9 784pm.

I realise that from a net perspective, he will bank less (R32 716 vs. R37 405), but from a savings perspective, not only is he saving R7 500pm towards retirement, but he is saving R2 811pm in tax payments every month.

If we move onto the myth where some believe that you don’t need to contribute towards an RA as the tax benefits are pointless due to the fact that you will pay tax on your income anyway – the only way to see if this is true, would be to test it. Let’s suggest that two investors had to make that choice 20 years ago (31 January 1999), and that one decided to invest his 15% in an RA, while the other decided to invest his 15% directly. The results were very interesting.

For the purpose of this exercise, we will assume that both of them required at least R32 716pm to live on, that they had no annual salary increases, and that both of them invested 75% of their contribution in local shares (FTSE/JSE All Share Index) and 25% in local bonds (SA All Bond Index). The person with the RA would have invested R7500pm, while the direct investor would have invested R4 689pm. I haven’t taken any adviser fees into consideration, but I did apply a 0.58% annual Retirement Annuity Fee, which would not have applied to the direct investor.

 

Graph 1: Hypothetical representation of an investor saving via RA vs. an investor saving in direct investments over the past 20 years (source: PSG Wealth Old Oak)

After 20 years, the investor who invested directly would have had an investment total of R4.74 million, while the investor who saved his portion in an RA, would have had a whopping R7.58 million.

If both of them retired after this 20-year period and decided to make a 6% monthly withdrawal from their retirement funds, the person without an RA would have been able to withdraw R23 716pm, while the person with the RA would be able to withdraw R37 915pm. Although this is quite a bit more than the direct investor, he would have to pay income tax on his monthly withdrawal. If we use the current tax rates and work under the assumption that those rates never changed after 2018/2019, he would still be earning a much heftier after-tax income of R29 781.60 (taking rebate of R14 067 into account).

Obviously, the investment environment, tax legislation and costs may change over time, but the difference between these to hypothetical investors seems to be 20% in favour of the person that followed the RA route.


The opinions expressed in this blog are the opinions of the writer and not necessarily those of PSG. These opinions do not constitute advice.  This is intended as general information and does not form part of any financial, tax, legal or investment related advice. Although the utmost care has been taken in the research and preparation of this blog, no responsibility can be taken for actions taken based on the information contained in this blog. Since individual needs and risk profiles differ, it is always advisable to consult a qualified financial adviser before taking action.

 

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