In the second part of 10X Investments’ Rands and Reason educational series, Chris Eddy, Head of Investments at 10X, gives the low-down on tax incentives for retirement saving
It’s March, which means it is the beginning of the tax year, the perfect time to start planning to make the most of tax breaks, such as incentives offered on retirement saving. Avoid a scramble in February next year by starting this month.
While every asset manager will have a different view on which shares to hold in your retirement portfolio, they will all agree that the best place to hold your portfolio is within a SARS-approved retirement fund per the Pension Fund Act (PFA).
The PFA governs pension and provident funds (employer-sponsored group schemes) as well as preservation and retirement annuity (RA) funds (for individual investors).
Apart from the structure and discipline that attaches to these funds in the form of regular compulsory contributions, restricted access and professional oversight, they also provide important tax benefits that make saving more affordable and boost your retirement income.
Unlike private investments, contributions to a formal retirement fund are tax deductible. You may deduct contributions (made by either the employer or yourself) up to 27.5% of your taxable income or gross remuneration (whichever is the higher). The 27.5% limit applies to the aggregate of contributions to all funds (pension, provident and RA). The overall tax-deductible limit is R350,000 per annum. Contributions over the annual rand limits may be rolled over to future years, subject to the limits applicable in those years, or else they are returned tax-free at retirement.
The state wants people to be able to fund their retirement themselves and not become dependent on government, which is why there is a tax benefit offered to people who contribute to a retirement annuity.
This tax-deductibility softens the immediate blow to your take-home pay. If your marginal (highest) tax rate is, say, 36% (assuming an annual income is R500,000), then for every R100 you save, your take-home pay reduces by only R64.
Although you do eventually pay tax on these contributions when you draw on your savings, this will be at the average tax rate applied to your benefit (be it a lump sum or annuity income). Invariably, this will be lower than the marginal tax rate on your earnings. If your savings eventually afford you an annuity income of R350,000 pa (a 70% income replacement ratio on the example mentioned earlier) this will attract an average tax rate of 18.5% (based on the current tax tables). That’s a permanent tax saving of R17,50 for every R100 contributed to your retirement fund in the above example, every year.
The other important advantage is that you do not pay tax on the investment returns earned on your account, be it on capital gains, dividends or interest. If you save privately the annual tax you pay on these returns is a cost that lowers the return of your portfolio.
Morningstar, in its Global Fund Investor Experience Study 2017 estimated this tax drag on a local high equity portfolio at 1.23% annually. Retirement fund members don’t pay this tax. Compounded over 40 years, this annual cost saving translates into 30% more money after 40 years.
You may transfer the proceeds of your pension or provident fund tax-free to a preservation or RA fund in the event you resign, or are dismissed or retrenched. Doing so preserves both your accumulated savings and the attached tax benefits, including the favourable lump sum tax rates that apply at retirement. These lumpsum tax concessions are greatly reduced if you cash in early, as the table below illustrates (the additional tax on the first R1,050,000 would be R94,500).
If saving is good, then saving more is better; it makes sense to exploit the available tax concessions to the extent of your means. If you are saving 10% of your earnings, shoot for 15%. While the impact on your monthly take-home pay will be modest (less than 5%), you stand to boost your retirement benefit by 50%.
If you feel that you cannot afford to increase your monthly contribution, consider making ad-hoc lump sum contributions to your pension, provident or RA fund when you can afford to. Most pension and provident funds allow for an AVC – an additional voluntary contribution – that can be processed through the employer payroll to give you the immediate tax benefit. Your HR department should be able to assist you with this.
An additional voluntary contribution is something you may want to consider if you are in line for an annual bonus, or a 13th cheque. Much of this money is earmarked for domestic employee bonuses, family gifts, entertainment and vacations. These expenses do not fall away once you have retired so it makes sense to save specifically for them, out of your bonus.
If your fund rules don’t permit an AVC, consider using the additional money to set up an individual RA, or make a top-up contribution if you already have one.
The bottom line is that retirement funds offer the most legitimate and morally acceptable tax avoidance scheme on the market. Your money does not even have to travel to Mauritius for you to supersize your retirement income. But you must do your share: if you don’t save, you won’t get your share of the tax breaks.