In the second part of our "How to" series on saving for retirement, we look at how the impact of tax should be a key consideration when you choose a savings vehicle.

You have numerous investment choices when you save for the long term, Mandy Porter, a senior financial planner at Alexander Forbes, says. These choices range from putting your money in the bank (not a good thing, because you are unlikely to receive a real, or after-inflation, return) to collective investment schemes (including unit trusts and exchange traded funds).

Before you start saving, you need to set the correct savings goal and choose the appropriate financial instruments. For example, if you are saving to buy a property, you will use different savings vehicles than those for saving for retirement.

"The important thing is that you plan your finances holistically, taking account of all your financial needs," Porter says.

"You should not make decisions in isolation of each other. You should have an accredited financial adviser assist you in drawing up a financial plan, and you should review the plan regularly."

Porter says the key to proper financial planning is to budget for both the short and long term, taking account of things such as the repayment of debt; assurance against the unexpected, particularly life, disability and health assurance; and how much you can afford to save.

Porter says often you have no choice about how you save for|retirement, and you have to take account of this in your planning, both now and in the future.

For example, it may be a condition of your employment that you join an occupational retirement fund provided by your employer or a trade union.

On the other hand, if you are self-employed or work for an employer that does not provide an occupational retirement fund, you will have to save for retirement using a retirement annuity (RA).

However, if you believe that your business might fail or that you might change employer to one that provides an occupational retirement scheme, you will have to be careful about your choice of RA if you want to avoid having to contribute to two retirement funds.

Most RAs provided by life assurance companies commit you to saving for a contracted period. If you stop paying the contributions, you can be subjected to a penalty of as much as 15 percent of your accumulated savings, depending on how long you were a member. So the better choice would have been to save through a unit trust RA, on which there are no penalties and where the contributions can be flexible.

In saving for retirement, you need to know, based on your current and future total earnings, how much you will need in retirement, taking account of the percentage of your final salary you would like as a pension (known as your net replacement ratio, or NRR).

When calculating your NRR, you need to determine how much post-retirement medical cover will cost, as well as provide for an emergency fund so you have money for things such as a severe health condition or a new car after an accident.

Once you have a proper financial plan, you can start making decisions about what investment vehicles you need to use for long-term savings, such as retirement.

The main advantage in saving for retirement is that there are tax incentives to encourage you to do so. You receive these incentives while you are saving for retirement, at retirement and in retirement.

The government provides tax incentives because it does not want to have to support you in retirement. This is also why it penalises you if you withdraw your money before you retire.

Currently, the retirement tax system favours upper- and middle-income groups, whereas the benefits for low-income earners are limited.

Deferred tax works to your advantage

The taxation of retirement savings is based on the tax being deferred until you are retired and, preferably, are receiving a monthly pension.

The major benefit of deferred tax is that you receive investment returns on money you would otherwise have paid to the taxman.

There are three stages to the taxation of retirement savings:

1. Build-up

There are two main types of retirement-savings vehicles for taxation purposes:

  • Provident funds. Your contributions are made with after-tax money, but any contributions made by your employer (up to an amount equal to 20 percent of your pensionable income) are not added to your taxable income. The investment returns are not subject to income tax or capital gains tax (CGT).

  • Pension funds, including retirement annuity funds. You can deduct from your taxable income the contributions paid to a pension fund up to 7.5 percent of your pensionable salary (normally your basic salary without allowances and bonuses) and up to 15 percent of your total taxable income less any amount you save in an occupational fund. In effect, you are receiving a tax rebate equal to your marginal rate of taxation on the contributions you make.

    So if you earn between R305 001 and R431 000 a year and are on a marginal rate of 35 percent (2010/11 tax year), you are, in effect, receiving|35 cents for every rand you and your employer save for your retirement tax-free. And you will earn returns on that 35 cents until you withdraw the money.

    If you are on the top marginal rate of 40 percent, you are, in effect, receiving 40 cents for every rand you and your employer contribute.

    However, you receive no tax deductions on your contributions if you earn below the tax threshold of R57 000 a year (R4 750 a month) for people under the age of 65 or R88 528 a year (R7 377 a month) if you are aged 65 years or older (for the 2010/11 tax year). Any contributions your employer makes to your fund (up to an amount equal to 20 percent of your pensionable income) will not be added to your taxable income.

    Investment returns are not subject to income tax or CGT.

    2. At retirement

    How your retirement savings are taxed when you reach retirement age depends on whether you are a member of a provident fund or a pension fund:

  • Provident fund. You withdraw all your money as a lump sum, which is subject to tax.

    Any contributions you have made to the fund are deducted, because you have already paid tax on this amount. The balance, which is made up of any employer contributions and investment growth, is taxed according to the lump sum taxation table (see "Lump sum tax: withdrawal benefit versus retirement benefit" and "Tax rates for retirement lump sums").

  • Pension fund. You are permitted to withdraw a maximum of one-third of your accumulated retirement savings as a lump sum, which is taxed according to the lump sum taxation table. You must use the rest of your savings to purchase a pension.

    Note the following:

    1. The tax benefits are cumulative. You cannot claim the same benefit more than once. This includes any early withdrawal benefit (a withdrawal before retirement) you received.

    2. CGT does not apply to a provident or a pension fund.

    3. In retirement

    If you receive a pension bought with the benefits of a pension fund, you will pay income tax at your marginal rate of income tax. (Again, CGT does not apply.) You are still receiving favourable tax treatment because:

  • You are deferring tax on the balance of your accumulated retirement savings, so you are earning investment returns on money that would otherwise have been paid to the taxman; and

  • You are likely to be on a lower marginal rate of tax than you were when you were still working.

    Lump sum tax: withdrawal benefit vs retirement benefit

    Lump sums paid out from a retirement fund are taxed as either a withdrawal benefit or a retirement benefit. The following is regarded as a withdrawal benefit:

  • A lump sum you withdraw from your employer-sponsored retirement fund when you resign from your job;

  • A lump sum you withdraw from your former spouse's retirement fund, because it was awarded to you in a divorce order made on or after September 13, 2007; and

  • A lump sum you transfer from a pension fund to a provident fund.

    The following is regarded as a retirement benefit:

  • A lump sum paid to you when you retire. (In the case of a provident fund, you may withdraw the full amount, but in the case of a pension fund, you can withdraw up to one-third of your savings.)

  • A lump sum paid into your estate or to your beneficiaries on|your death.

  • A lump sum paid to you when you are retrenched or made redundant.

    Before any tax is calculated, you are entitled to make certain deductions from the lump sum. The main ones are for amounts you:

  • Transfer to another pension fund, pension preservation fund or retirement annuity fund;

  • Contributed to the fund that were not tax-deductible;

  • Transferred to another fund for the benefit of a former spouse in terms of a divorce order made on or after September 13, 2007 and the amount accrued to the ex-spouse on or after March 1, 2009; and

  • Saved in the Government Pension Fund before March 1998 that are regarded as tax-free and|that have been transferred to another fund.

    Example: retirement with previous withdrawal

    John Dludlu retires on September 30, 2010 and receives a lump sum of R950 000. He previously resigned from a pension fund on April 1, 2009 and withdrew a lump sum of R300 000. The tax on the R300 000 was calculated as follows:

    R22 500 is tax-free

    R300 000 - R22 500 = R277 500

    18% of R277 500 = R49 950

    When John retires, his tax is calculated as follows:

    R950 000 (lump sum taken in 2010) + R300 000 (lump sum taken in 2009) = R1 250 000

    Tax on R1 250 000 according to retirement tax table (see "Tax rates for retirement lump sums", below):

    R135 000 + 36% of R350 000 (R1 250 000 - R900 000)

    = R135 000 + R126 000

    = R261 000

    Notional tax on R300 000 = R0

    Tax on lump sum = R261 000

    Tax rates for retirement lump sums

    For withdrawal benefits

    Up to R22 500:0% of taxable income

    R22 501 to R600 000:18% of taxable income above R22 500

    R600 001 to R900 000:R103 950 + 27% of taxable income above R600 000

    R900 001 and above:R184 950 + 36% of taxable income above R900 000

    For retirement benefits

    Up to R300 000:0% of taxable income

    R300 001 to R600 000:18% of taxable income above R300 000

    R600 001 to R900 000:R54 000 + 27% of taxable income above R600 000

    R900 001 and above:R135 000 + 36% of taxable income above R900 000

    Tax breaks make a difference

    Here is an example of how tax incentives benefit your retirement savings. (This is an estimate because many factors affect the calculation.)

    John Dludlu gets his first job at age 25. His starting pensionable salary is R8 000 a month. His salary increases at an average rate of|six percent a year (equal to expected future inflation). At retirement, 40 years later, his pensionable salary is R82 300 a month (in nominal terms).

    John had the choice to save his money in an occupational retirement fund or a unit trust fund. If he chose an occupational retirement fund, he would receive tax benefits.

    John contributes six percent of his pensionable income to an occupational fund and his employer contributes a further six percent. At retirement, John has accumulated R8 175 292, assuming an average annual real rate of return (after deducting inflation) of four percent.

    Let's estimate that John saved R125 687 a year on average. This in turn earned him R3 147 816 in investment returns over the 40 years.

    If John had invested in a unit trust with the same underlying investments as the occupational fund, he would have accumulated about R6 694 739 after 40 years, because he would have used after-tax money and paid tax on the interest. On cashing in his unit trust, John would also have a capital gains tax liability.