Before I begin, let me advise you to move forward here with caution. This blog post deals with tax efficiencies – which are “utterly disgusting” according to at least one Labour MP. And be warned that, some day in the future, someone may publicly say:
“He’s not a very clever boy, he’s a very average boy who used privilege rather than brains to get where he got. Perhaps we could all buy our babies a better life if only we weren’t burdened with being decent human beings.”
I didn’t realise that being a “decent human being” requires you to pay the most amount of tax possible.
But if you choose to define “decent” differently (I do), and if you choose to see tax structuring as something that we all aim for, then read on.
I’ve been asked to revise an old post about Retirement Annuity Funds – mainly to deal with some of the updates in the SA tax law.
Here’s the old post:
This may seem to be outside the realm of interest for the non-South-African taxpayer – but most governments are concerned around their ageing populations, so they’ll have some kind of tax incentive available for retirement savings (so some of what’s in here might be applicable).
Here’s the thing: one of the best returns you can get for your money is a tax-saving.
A Tax-Inefficient Scenario
- I’m an ordinary income-earning person under the age of 55.
- I earn a package of R400,000 per year.
- From that, I pay for my medical aid each month – but other than that, I don’t really do much else that gets me a tax deduction.
- For the 2014 tax year, I’d be paying around R78,600 in tax.
- So I’d have R321,400 of money that would land in my bank account in monthly instalments of R27,000.
- From that, perhaps I’d like to start saving – so I try to put away R5,000 each month into an investment portfolio of my choice.
I chose R5,000 quite specifically – because as it
stands today stood then, SARS let you claim an income tax deduction of up to 15% of your non-retirement funding income if you placed it into a Retirement Annuity Fund investment.
And don’t be put off by “non-retirement funding income” – all that SARS is saying is that you can’t contribute both to a pension fund* and to a retirement annuity fund and then claim full deductions for both. If you’re already taking advantage of a pension-fund contribution – then you’re limited to 15% of whatever income is left over after than contribution is taken off.
*There is already a separate tax incentive for pensions. Retirement Annuities are for those that might want to save more.
A Tax-Efficient Scenario Though
If you place yourself in exactly the same position (earning R400,000 and trying to save R5,000 per month), and instead of placing that R5,000 in unit trusts yourself, you place it into an Retirement Annuity Fund (RA), your tax bill drops from R78,600 down to R59,500.
That’s a tax saving of R19,100, or about R1,600 per month.
But the important thing is that it would add directly to your return. In other words, just by shifting your investment strategy with your R5,000 monthly saving, you can earn an instant return of 32%*.
*1,600 ÷ 5,000 = 32%
That kind of once-off return is pretty hard to catch-up with, once you get going. Someone has already done the math (here’s a link to the paper), but basically, this is a graph of the extra return your discretionary investment would have to make each year in order to catch up with a fairly low-yielding (5% per annum) Retirement Annuity Fund:
In my R400,000 per year case, my discretionary investment would have to outperform my RA investment by 3% every year for as long as I have the RA. That’s, well, quite an ask.
The Big Forthcoming Change
With effect from the beginning of March
2015 2016 (the bill was delayed), the 15% limit is increasing to 27.5%. Although, because the tax man always taketh away with the other hand, there is going to be an overall monetary contribution limit of R350,000 per annum – which means that anyone that was taking advantage of the 15% contribution on high incomes (circa R2 million annually and upwards) is going to find themselves taking smaller deductions for their RA contributions.
Other Good News
Retirement Annuity Funds, because of their tax advantage status, have traditionally attracted high-fee-charging fund managers. Which actually makes a lot of sense – if there is a 32% instant return, you wouldn’t necessarily quibble if 50% of that was taken by a fund manager, right?
I mean, if someone said to you “you can earn a 16% instant return just by investing in our RA!” that sounds like a good deal. Maybe not as good as 32% – but rationally, you’d still do it.
But here’s the good news: there are now passive index-tracking RA funds charging fees that are capped at figures like 1.35% per annum.
My only real complaint when it comes to RA Funds is that their investment allocations are governed by Regulation 28 in the Pension Funds Act – meaning that no Retirement Annuity Fund can be pure equity (how annoying).
But that’s really just semantics. Most small investors would choose a balanced fund anyway – so why not choose one that gives you a tax saving?
A Final Observation
For those that are going to come back at me with “but you can’t touch your RAF fund until you’re 55” – I’m just not convinced that’s such a bad thing… I mean – isn’t the point to have savings for your retirement?
So really, I guess I’m saying that if the object behind your savings process is to buy a house or pay for December’s holiday, then you do that out of post-tax income.
But if you want to save for retirement, do it pre-tax.
We’re now two years down the line, and the new 27.5% limit has come into play.
The question is: what difference does it make?
Well, in the above example, the main difference is that you can now save the tax saving as well. Let me try to illustrate that:
- Let’s say that all you have to save is R5,000 per month, in like actual-cash-out-of-the-bank-account.
- Under the first Scenario (Scenario A), you could save R5,000 of after-tax income, which would come straight out of the kitty.
- But if you wanted to be more tax-efficient back in 2014 (Scenario B), then you could have put R5,000 in a RA fund, and claimed back R1,600 per month from the tax man. That is, your effective saving plan would have cost you R3,400 per month – in return for which, you’d have had R5,000 per month in the RA. Then, if you’d wanted, you could have then put the R1,600 tax saving into a unit trust, making the total personal savings amount R6,600 per month.
- But now in 2016, because the contribution limit has been raised to 27.5%, one could throw everything into the RA. That is: the after tax contribution would be the R5,000 – making the full contribution worth around R7,400 (using those 2014 tax numbers).
|Scenario||Cash that you’re out of pocket per year||Total amount in savings per year|
|Scenario A – no RA||R60,000||R60,000|
|Scenario B – old RA||R60,000||R79,200|
|Scenario C – new RA||R60,000||R88,800|
Which is a pretty great return, rand for rand.
That said, there is a downside. There’s an annuitisation requirement: which means that on retirement (at age 55), you’re allowed to take a third of your RA savings out as a lump sum, and the rest has to be used to buy an annuity product (which will payout a given amount per year for a given period). It’s not the worst thing in the world, but it is a drawback.
I guess the question is: if I gave you a guaranteed extra return of 48% for every contribution that you made, would you go for it?
Here’s a graph, assuming a real return of 2% per annum, and savings from age 30 to age 55 (when you can officially cash in the RA):
It’s worth considering (at the very least). Even if organising your tax affairs this efficiently is so… utterly disgusting.
Rolling Alpha posts about finance, economics, and sometimes stuff that is only quite loosely related. Follow me on Twitter @RollingAlpha, or like my page on Facebook at www.facebook.com/rollingalpha. Or both.