The tax benefits on retirement contributions and the tax free growth, the fact that pension income benefits are taxed has led people to question whether saving in a retirement fund really is better than making your own retirement savings arrangements with after-tax earnings.
One of the main ways the government encourages people to save for retirement is to offer tax deductions on saving in an approved retirement fund. While this tax relief can be helpful when you’re working and contributing to a retirement savings fund, the benefits you eventually receive from your retirement fund when you stop working are still taxed.
To help South Africans make informed retirement saving decisions, Old Mutual Corporate Consultants conducted an investigation into how tax impacts retirement outcomes. The analysis aimed to compare the tax impact of various vehicles to save for retirement. The three vehicles considered were a retirement fund, discretionary savings (that is using after-tax income), and a tax-free savings account (TFSA).
Five scenarios (using different combinations of these three vehicles) were compared:
Scenario 1: Discretionary savings only (Discretionary)
Scenario 2: Discretionary savings, but including saving in a TFSA (Discretionary TFSA)
Scenario 3: Saving in an approved retirement vehicle (Retirement)
Scenario 4: Saving in an approved retirement vehicle and also reinvesting any tax savings on a discretionary basis (Retirement Plus)
Scenario 5: Saving in an approved retirement vehicle, and reinvesting any tax savings in a TFSA as well as in a discretionary vehicle (Retirement Plus TFSA)
The analysis also considered different levels of income.
Three levels of pre-tax income were compared: R20000 a month, R60000 a month and R120000 a month.
In all five scenarios, and across all three income levels, the full impact of tax was modelled to compare the impact over the lifetime of an individual.
The analysis provided some valuable insights. As expected, it shows that the Retirement scenario (Scenario 3) provides the best outcome in terms of income after tax, both before and during retirement. The difference is significant. Based on the same level of take-home pay before retirement, the Retirement scenario provides an after-tax pension that is just over double the income under the Discretionary scenario (Scenario 1).
By contrast, the Discretionary scenario provides the worst retirement outcome across all three income levels. This is because the additional tax being paid on your salary, due to not benefiting from retirement contribution tax deductions, leaves little money over to make a substantial post-tax contribution to discretionary retirement savings.
Although the Retirement Plus scenario (Scenario 4) also produces a much better outcome than the Discretionary scenario, it still did not quite match up to the pure Retirement scenario. For a person earning a R60000 a month gross salary, the Retirement Plus scenario provides an after-tax pension that is 75% higher than under the Discretionary scenario, compared with an extra 102% in the Retirement scenario.
Introducing a TFSA does improve the outcomes of both the Discretionary TFSA (scenario 2) and the Retirement Plus TFSA (scenario 5), but they still fall short of the Retirement scenario (scenario 3). This is because the TFSAs only provide tax relief on growth and there are limits on contributions.
Andrew Davison is head of advice at Old Mutual Corporate Consultants.