Understanding when and how you pay tax on retirement funds
Most of us are aware that with certain retirement contributions (pension, RAs) we can get a tax rebate on the premiums, up to an annual maximum. If you’re in a high tax bracket, this could be thousands of rand. Not just that, the investment is not taxed within the fund either. No CGT, no tax on interest, no tax on rental income, and the dividend tax is rebated back. If you have two identical investments, same funds, same platforms, the retirement fund is going to outperform the flexible investment. If you plough back your rebates,even into a TESA or Flexible investment, then it will grow by orders of magnitude more. So… Is this the best and only way to go?
You always pay tax. It’s just a matter of when. With retirement investments you are just deferring that tax. Either you invest after tax (and then still get taxed within the investment – with the exception of TESAs which I will talk about later) or you Invest before tax, and get taxed when you retire.
For most people, your tax bracket increases over time. Getting to the 40% bracket is easier and easier. It’s a nasty little trick called ‘bracket creep’ – the government doesn’t increase the tax bracket, it just lets inflation push you steadily into a higher bracket by moving the limits at below inflation rate every year. (The top bracket has been at 40% since 2002, but that might change next week). In other words, if you’re young your rebates at 18% marginal tax rate are going to be less than when you hit 40%. If you’ve been planning properly, from a young age, you should be able to retire on close to 100% of your last salary, leaving you at that final tax bracket. You do gradually get better rebates from tax, but these are pitiful.
When you retire from an RA, Pension or Pension fund, you can take 1/3 as a lumpsum and the rest as a compulsory annuity. Compulsory annuity = INCOME = Taxable! The lumpsum however is CAPITAL, and the first R500k is tax-free (PLUS any of the contributions you made (as opposed to being made by your employer) into a Provident fund, because those would have been after tax. SARs also add back any excess premiums that haven’t be used as a tax deduction). You have two choices for the compulsory annuity – a ‘living’ or ‘life’ annuity. The life annuity is linked to the interest rate at the time you take it out, and can be made to increase at inflation (with a lower initial payment of course) but usually disappears when you die. Frankly, I am not a fan. Living annuities give you much more flexibility, and if you keep the percentage you take out below 6%, you can still get it to last 20-30 years. If you die before it runs out, the balance goes to your beneficiaries. If you want to read more about RAs, you can go HERE.
That tax-free lumpsum (R500k) should be invested too, probably in a flexible investment, but don’t lump it in with your compulsory annuity. You’ll be turning a tax-free lumpsum into an income to be taxed at your marginal rate! By the time you retire, there should be no debt to pay off, but if there is, then use the lumpsum for that. That lumpsum can then grow to produce an income or for capital expenditures like buying a new car (once you’re past retirement age you’re unlikely to get credit for a car or house).
So… How does this compare to that flexible investment you made at the same time? That is 100% capital, none of it is treated as income. You will have been paying tax as you go, and as you start selling bits of it, you will pay Capital Gains Tax. Every year we get a tax allowance for CGT, it’s currently R30 000 pa. On most platforms, and certainly on LISP platforms (that I use almost exclusively), you can easily turn a flexible investment into one that pays you monthly, in exactly the same way that a pension does. The big difference is that this is not Income, so it’s not taxed as income, and doesn’t push you into a higher tax bracket.