One of the great characteristics of a retirement annuity is the ability to defer income tax on your interest, dividends, and capital gains until such time as you actually withdraw amounts out of your RA in retirement.
If you think of tax as a cost (which it is), and you consider how avoiding this cost is possible within an RA, then you must realise the long term benefits of avoiding tax within your RA, especially when you recall that discussion we had on compounding and compounded costs that add no value. We don’t think paying tax adds any value to your investment balance.
When it comes to investing and doing what you can to get more out of your investment balance, paying attention to things like taxes is one of the few things you can actually do, given that the market is going to do what it wants regardless.
In addition to the tax-deferred nature of an RA, you are also entitled to an annual income tax deduction for your contributions to an RA. The taxation of the contributions to formalised retirement savings vehicles has recently gone through a complete overhaul. Right now you get a deduction of 27.5% of the greater of “remuneration” or “taxable Income” – subject to an annual limit of R350,000. This limit is for the deduction itself and not for your salary on which you multiply by 27.5%.
“Remuneration” and “Taxable income” are both complicated definitions in the Income Tax Act, but you can think of both of them as simply being your salary from your employer, or your earnings from your business.
This deduction means you get to claim money back from SARS, and effectively get a refund equal to your effective tax rate multiplied by your RA contributions. So if during the current tax year, you contribute R30,000 to an RA, your refund from SARS would be in the region of R9,000 with a 30% effective tax rate, provided that you earned in total more than about R110,000 in that tax year.
This refund from SARS does not in any way affect your RA or your investment balance.
It is unlikely that many people would reach the annual threshold of R350,000 or be contributing more than 27.5% of their salary, so don’t think that there is no incentive to look for the deduction.
Your refund from SARS is yours to do with as you please, but should you put it back into your RA. You can think of it as free money.
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This revision and increase in terms of how much you can claim as a deduction for your RA contributions, is all part of National Treasury’s plan to promote a culture of savings in South Africa. Historically, people’s contributions to their formalised retirement products like RAs, pension, and provident funds, was largely aligned with the tax deductions available for these contributions. People didn’t feel like they should be investing anything more than what SARS gave them credit for.
We’ll get around to discussing how much you should be contributing towards retirement soon enough, but we can tell you that if you are one of these people who have been limiting your investing every month to only that for which you previously got an income tax deduction (typically 7.5%), then you’re likely to be woefully short on your needs.
The minister of finance hopes that by allowing for additional tax incentives in the retirement industry, that people like you and the WellSpent editorial team will all think a little longer and harder about the importance of saving for retirement. Sometimes a carrot works better than a stick.
When you do ultimately reach the age of 55 or retire subsequent to that, you may elect to ‘annuitize’ your RA and start to get an income stream from it. Any amount that you receive from your annuity will be taxed as if it were a salary you were earning. The life company who pays you the likely monthly annuity, will even withhold PAYE and pay you the net amount. How much exactly you pay in tax every month will depend on where you sit on the tax tables.
These are the same tables that currently dictate how much you pay in tax every month in your formal job; higher earners pay more. We’ll hazard a guess and say that you’ll most likely pay less tax in retirement, as your total income will be less. So while you might pay income tax at an effective rate of about 30% now, it could drop to the low 20%’s in retirement.
It’s always difficult to try and make a call on these things by comparing current tax rates, the value of your deduction now, vs. what the tax rate might be in the future. Some people might be nervous that tax rates in the future might be very high, so while it’s all very well and good to get a deduction now, they don’t want to be paying possibly huge amounts of income tax in the future.
The Editorial team knows tax, but it doesn’t know the future.
In times like these we remind people, not to let the tax ‘tail’ wag the ‘retirement ‘dog’. Do what makes sense now, given your circumstances and finances, and pay less attention to what South African income tax might look like in 25 years’ time.
The end of February marks the end of every tax year, which also marks the cutoff for that tax year’s RA tax deductions. The great thing about an RA, is that your contributions are not limited to monthly amounts. If you wake up on 1 Feb and suddenly decide to start an RA, you could invest as much as you wanted to, to kick things off, and claim that full deduction (subject to limitations) for that tax year ending 28 days later.
This is why the end of the tax year is such a great time to reflect on your retirement efforts for the year gone by, and an ideal time to play catch up if need be. We’ll do you a favour and remind you again in January about this. You can sign up to our newsletter to definitely get the reminder.
We will still publish an article on what to do when you have left retirement planning a little late in life, but we’ll share some of that wisdom now given that we’re on the topic of tax.
The use of a tax-deferred vehicle for retirement accumulation is nothing new. It is used globally as a way to encourage and promote retirement savings. If you can recall in our article on investing vs. speculating, we stressed that there will be times when it may seem attractive to depart from good judgment and go in search of shortcuts and things that seem too good to be true, only to discover that they in fact were.
If you’re feeling the pressure of having left things a bit late, it is crucial to trust in the basic principles of long-term investing and appreciate that avoiding tax as an unnecessary cost, is mathematically proven to provide for an exponential increase in the compounded growth on your investment assets. The journey is long and these things take time. Sometimes the only way to really believe or appreciate the difference it does ultimately make, is to listen to sound judgment like our own, or to punch some numbers into a financial calculator and see it for yourself.
There are many ways to provide for your own retirement, but we would seriously ask that you set aside some time, possibly even in the company of a financial advisor, and explore how an RA might complement your retirement goals.
We’ve written quite a few other great pieces on how tax affects your various investments and retirement outcomes – here they are:
If you have any questions on any of them, give us a shout!