Retirement Annuities – the demon revisited

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Monet's garden, Giverney

Monet’s garden, Giverney

Should you top up your RA before the tax season ends?

It is ‘retirement annuity (RA) season’, any contributions you can get into your RA before the end of the month can count toward your tax deduction for this financial year. If you have been ignoring all that advice, advertising and appeals from your broker like the plague, I don’t blame you. I have been around long enough to be tainted by some of the appalling business practices around insurance company RAs (and company pensions) myself, some of which still hang around today. With all the investment options available now, is there a place for retirement annuities today?

With the exception of a tax-free savings account which is capped at R33,000 pa, there are very few tax-efficient investment vehicles out there. Endowments are not ‘tax-free’, they are taxed within the fund at 30%, so unless your average tax rate is well above this, and you have maxed out on your annual interest and CGT allowances, they aren’t going to give you much real tax relief (except of course being out of sight so out of mind). They do however work really well for investments in a Trust.

Before looking at how tax effective an RA can be, let me just put some caveats in place: In my opinion, never use an insurance platform, nor add to an existing RA you already have on an insurance platform (beyond that which you are contracted to do so). Why? There are still nasty things called ‘early termination penalties’ that they can impose on your investment when life happens and you dare to want to reduce or stop the contribution. These penalties are levied because insurance companies pay brokers all the commission on the policies, for years into the future, at the start of the policy. Use a LISP platform.

The government have started to limit the amount of contributions you can deduct off tax – now at 27.5% of your taxable income or R350k pa, whichever is the lower. Taxable income can include interest on investments, rental income or income from other sources like commission (but allowable expenses related to these, like home-office or rental expenses, must be deducted first). At least these days all retirement savings – pension, provident fund and RAs are all lumped together for this allowance – in the past, if you had a company pension, irrespective of how much or little it was, you could only claim a minuscule additional portion of your RA.

Let’s have a fresh look at the tax savings you can get. Firstly you can get a refund on your RA contributions (or use them to increase your tax-home pay by claiming an immediate benefit). If your marginal tax rate is 40%, that refund (or reduced tax liability) can be huge. Secondly, there is how your investment is taxed within the fund, or more accurately, how it isn’t. There is no tax on interest, capital gains, yield and the dividend withholding tax (20%) is rebated back. If you had exactly the same amount of money in exactly the same funds in an RA and a flexible investment, you would get IT3s for SARS on interest, yield and capital gains in the flexible investment and be taxed accordingly, in the RA this is reinvested with no tax. The higher your tax bracket (and if you’ve maxed out on your pitiful interest allowance) the bigger this impact will be.

Okay – it’s not all sunshine and roses. That tax is deferred to a later date and takes a different shape, but it’s worth doing the math. If you intend to partially retire then it may make sense to have more than one annuity – retiring from one when you partially retire, then the other when you fully retire. Your financial planner can help you with the specifics on that. You can of course (as the legislation stands right now) decide never to retire from it and then it will fall into your estate duty-free (except for any excess premiums – see below).

In order to be truly tax efficient your future income at retirement/semi-retirement should probably be invested in a number of different buckets, and if you’re in the 40% plus tax bracket then even endowments should be considered.

Should you make your maximum contribution allowed to an RA every year? Well… Ja/Nee. You need to work out how much you need to put away to retire in the manner in which you have become accustomed. That is going to depend on how big your pot is now, how many years you have to retirement, if you’re going to semi-retire, if you have other secure sources of passive income, how your pot is invested, how much you want to have at retirement, the expected growth of your investment pot, what inflation is going to do, how long you think you’re going to live and a bunch of other variables. Anyone who pulls a magic percentage out of the air like 15% of your income needs to go back to school. Of course, I am going to say that this sort of discussion is best had with your financial planner, but there are some programs and apps out there that will give you a reasonable result (as long as they allow you to play with the variables).

What about going over the maximum allowable contribution or cap? Shock and Horror! Actually, it’s not always the worst idea in the world. If you’re lucky enough to have a chunk of money invested (perhaps from an inheritance or sale of a business) that is attracting way too much tax, it might be worth doing some of the math and exploring this. Before considering this be aware of the small print – you can’t retire from this until age 55, and you’ll be turning capital into income at retirement. So, before dismissing the notion outright, let’s look at a R1m lump sum sitting in a money market account, your financial advisor has put a retirement plan together and these are funds you’re not going to need before 55, and may in fact never need. You are also in the 40% tax bracket and have maxed out your R23,800 interest allowance. In a flexible investment you’ll get R73,000 in interest and (simplistically) pay R29,200 plus in tax on that R1m. In 10 years, with reinvestment that is probably going to be more than R300k paid over to the tax man. Lost, gone forever to die a miserable death in the fire-pool at Nkandla. What about the refunds from SARS? You’d still get the maximum allowed and the rest will roll over as ‘excess contributions’ until you retire or they get mopped up. On retirement, if there is still an ‘excess’ it becomes part of your tax-free lump sum. Maybe not such an insane idea after all – in certain circumstances.

A lot of people get all caught up in before and after tax money and let this muddle their thinking. Income, once it has been taxed, becomes Capital. An RA eventually turns into capital, which is why it rarely, if ever, makes sense to put a large capital amount into an RA only to immediately retire from it (I have seen it done). At the moment compulsory annuities that form the ‘other’ 2/3 of your RA have to be withdrawn from at an amount equal to at least 2.5%, turning capital into income. The other 1/3 is capital, but may or may not be taxed (there is a R500k tax-free amount). If legislation changes and you don’t have to take any drawdown (it has been proposed) then this caveat falls away. If you want an investment to pay you an income/pension there are far smarter ways of doing this than buying and retiring from an RA.

Action:  Retirement Annuities, on LISP platforms, have a big role to play in your financial plan – while the government is still wanting us to save, take advantage of these tax benefits. If you want to get them into this tax year you’re going to gave to get to it quickly.

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Author Dawn Ridler ©

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