RA’s: Friend or foe?
If used effectively, it holds numerous advantages
By Cassie Carstens
01 Feb 2020
It is that time of the year where everyone reminds you that you should make your retirement annuity (RA) contribution before the end of February to reap the benefit in the current tax year.
To be honest, there is hardly another product that has such divided opinions about its usefulness, or not. It is one of those brushes that can’t be used to paint everything, but for certain clients, we simply cannot ignore the major benefit of allocating a large portion of their portfolio thereto.
The case FOR retirement annuities
Most people fixate on the income tax benefit of RA’s, but there are also benefits in terms of capital gains tax (CGT), dividend tax, estate duty and increased net returns on your investment. The list of benefits makes it hard for alternative investments to compete, which is especially the case for high net worth individuals with a high marginal tax rate.
Income tax benefit
In short, you can contribute 27.5% of your taxable income, to a maximum of R350 000, to any retirement product, and deduct it from your taxable income for the current tax year.
You are allowed to contribute more, but any contributions above the limit cannot be deducted in the current tax year but may be used in future tax years.
The problem is that most people do not make use of this benefit efficiently. They receive their tax credit once a year, but do not use it to top-up their investment.
CGT, dividend tax and tax on interest and rental income
Clients often lose sight of the fact that there is no tax on capital gain, interest or dividend income within the annuity structure. To illustrate the effect it has, we have compared the growth of one of the largest balanced funds in SA on a before- and after-tax basis.
See below graphic.
The difference – 2 percentage points per annum – is enormous. On an investment of R1million, the difference would have amounted to R450 000 in 10 years.
Can an RA reduce your capital gain?
The unbundling of Naspers in 2019, has left many investors with a large capital gains tax bill in the current financial year.
It is important to know that capital gains are included in your taxable income for the year, therefore by increasing your RA contribution (lest you remain within the R350 000 limit), you can claim more of your tax back.
Note that your deductible contribution is still based on
- Your maximum allowable amount according to the formula and
- The fact that your total claim may not be more than your normal income without the capital gain.
See the table below.
If you normally earn R200 000 per year, your allowable contribution will be a maximum of R200 000, irrespective of what your qualifying contribution is according to the formula.
Freeze estate duty
One of the largest benefits of RA’s is overlooked most of the time. If you make a lump sum contribution to an RA, a portion thereof will be deducted in the current tax year, to a maximum of R350 000. Any amount exceeding the limit is known as a disallowed contribution. Once you invest in a living annuity to generate an income, section 10(c) of the Income Tax Act allows you to deduct any previously disallowed contributions from income generated from your living annuity. You can therefore generate a tax-free income for years after retirement that would have otherwise been 100% taxable.
Keep in mind that any funds that you invest in an RA today, will freeze your estate to that amount, since any growth thereon will forever remain outside your estate. It is therefore an extremely attractive way to freeze the growth of your estate. However, the total value will not immediately be excluded from your estate for estate duty purposes, but can be materially reduced over time, while the value of your investment increases.
More about this in a separate article.
The argument against RA’s
Income is 100% taxable after retirement
Unless you have accumulated section 10(c) contributions, any income received from a retirement annuity will be 100% taxable. We would however argue that you are likely to save more tax now while earning at a high marginal tax rate than what you will be paying in future.
If you have planned effectively for retirement your total retirement provision is unlikely to be in RA’s only. If so, it will leave you with very little leeway and would be foolish.
You do not have access to your funds before 55
This is true, but in many cases actually a good thing. Once again, we do not believe that all your retirement savings should be channeled to RA’s. You need to have funds available in case of emergencies or for alternative investment opportunities so that you do not need to raid your retirement fund.
RA’s are inferior investments due to Regulation 28 constraints
Academically, this sounds about right, since a 100% exposure to shares and property, with no limitation on offshore exposure, should perform much better over time than a balanced portfolio that includes cash and bonds.
In practice, however, we don’t see many investors who chase the pot of gold at the end of the rainbow, and they hardly realise a better net return. If you utilise RA’s correctly by reinvesting your tax credit monthly, an alternative investment will have to outperform your RA by about 6% to beat it, even at a 31% marginal tax rate.
As mentioned previously, RA’s are not the solution to all problems, and not all RA’s are created equal, but you are depriving yourself of a powerful investment vehicle, if you do not have RA’s or do not use them effectively.
Cassie Carstens is a certified financial planner of ProVérte Wealth & Risk Management. Contact him at firstname.lastname@example.org.
Although all possible care was taken in the drafting of this document, the factual correctness of the information contained herein cannot be guaranteed. This document does not constitute advice and anyone planning on taking any financial action based on this document, is strongly advised to first consult with their personal financial advisor. ProVérte Wealth & Risk Management is an authorised financial service provider with FSP no. 5966.