2012 Budget makes the RA a powerful weapon

Two major changes announced in the 2012 National Budget will make the RA a more powerful tool than in the past. The first is the introduction of a 15% withholding tax on dividends – and the second an increase in Capital Gains Tax (CGT) from 25% to 33.3%!

The modern RA – and the Linked Retirement Annuity (LRA) – will be critical weapons in the financial adviser’s arsenal to assist investors to meet their retirement savings goal. There are two reasons for this.

First, the 10% secondary tax on companies (STC) was replaced by a 15% withholding tax instead of the 10% many experts expected. And second, the inclusion rate for CGT increased from 25% of an individual’s capital gains to 33.3%, pushing the effective tax rate from 10% to 13.33%.

Those relying on unit trusts or share investments to flesh out their long-term savings plan will be taxed on their dividends at a rate of 15%, resulting in far lower returns. And taxpayers who switch investments into lower or higher risk assets run the risk of triggering CGT events at the higher inclusion rate of 33.3%. When you consider the existing exemption of tax on interest you appreciate how powerful the RA is.

The law allows 15% of your taxable income to be placed into retirement products like pension funds and RAs, thus lowering your tax base.

From 2014 those aged 45 and under can deduct 22.5% (27.5% for the over-45s) of taxable income from contributions to retirement products. Annual deductions will be limited to R250 000 per annum (R300 000 for over 45s).

Modern RAs allow for switches between equity, bonds, cash and unit trusts or any appropriate asset class. It is also possible to take profits if the opportunity presents. This ensures the flexibility to manage your client’s investments over the long-term without worrying about the tax implications of investment decisions.

The clincher is that switching, profit-taking and income generation (in an RA) is free of tax. The compounding benefit of a like-for-like investment in a retirement annuity versus unit trust is enormous over 20 years. You earn 15% more on dividends, up to 40% more on your interest and property income and as much as 13.33% more on your capital gains!

To illustrate: Assume your client receives an annual bonus of R100 000 invested in an RA versus unit trusts. All else being equal the unit trusts will grow to approximately R560 000 after-tax over 20 years. The RA will return in the region of R1.37 million! (Calculation assumes the average return of the Balanced Fund over the past decade at 14% per annum, and average interest and dividend income earned on these investments over the period).

Remember – the RA incurs no tax deductions either at commencement of the investment or during the life of the investment. There is no tax on interest, dividends or capital gains either. Provided these "savings” are re-invested in the RA the magic of "compounding” does the rest.

The non-RA investment of your bonus immediately loses R40 000 to income tax, leaving R60 000 to invest. Over time this R60 000 is further eroded by withholding tax on dividends, CGT and tax on interest income. The net result is a significantly reduced return.

The tax benefits can be extended at retirement by transferring the R1.37 million into a Linked Living Annuity (LLA). This structure provides a higher income in retirement: R48, 101 per annum versus R25, 687 after-tax and CGT on post-retirement income. Another plus is that RAs and LLAs are free from estate duty! (Calculation assumes the LLA is taxed at 35% with a drawdown of 5% vs. drawing 5% on the unit trust income and pay tax on interest, dividends, and CGT).

RAs are an instrument that clients are obliged to leave "untouched” until age 55, thus creating a fantastic opportunity for long-term relationships between adviser and client. Given the current budget scenarios an RA becomes a win-win solution for both client and adviser. It creates far greater retirement wealth over the longer-term.