RA vs tax-free savings… a valid debate
Tax-free Savings Accounts (TFSAs) offer a range of attractive benefits and should be considered as part of a client’s savings plan. However, these accounts do not outshine Retirement Annuities (RAs) as a vehicle for retirement planning.
Financial planners should carefully consider their advice to clients if tax-free savings accounts are intended to be used as retirement savings vehicles.
There is a risk that tax-free savings accounts may be simplistically evaluated as superior retirement savings vehicles - based on the fact that, unlike RA’s, tax-free savings accounts offer access to savings at any time. Instead, a far broader perspective is required in giving clients financial advice in this context.
A holistic plan
The first imperative of financial advice is to consider client’s personal circumstances such as their time horizons, their available funds to invest, what income requirements they have and key personal considerations, to match those with their savings objectives.
While all of these aspects play an important role in the design of a holistic financial plan, the starting point is to first weigh up the relative tax benefits between tax-free savings accounts and RAs. Then, other benefits typically associated with an RA investment will come to play.
Clearly, both RAs and tax-free savings accounts earn tax-free investment returns. The important difference is that an RA defers income tax to post-retirement, whereas with tax-free savings account’s income tax is paid before every contribution is made.
Investable outcomes
Sanlam’s analysis shows that if a client with a marginal income tax rate of 40% invests R2 500 per month into a tax-free savings account, the client’s equivalent pre-tax contribution to an RA is R4 167 per month.
An amount of R2 500 per month is what it will take a client to reach the R30 000 tax-free savings account contribution limit per tax year. To reach the R500 000 life time limit, a client will need to invest this amount every month for 16 years and 8 months.
If the client saved through a tax-free savings account and an RA for 16 years and 8 months and earned an investment return of 6% per annum (after costs), the fund values would be R846 916 for the tax-free savings account and R1 411 527 for the RA. Although the fund value of the RA is higher, the client would still need to pay tax on the income drawn from the RA after retirement, whereas income drawn from the tax-free savings account would be tax-free.
If the client takes an income of 5% of the fund value per annum, he or she will receive R42 346 income per year from the tax-free savings account and a gross income of R70 576 per year from the RA.
If the client’s income tax-rate after retirement is still 40% and he or she invested a third of the R500 000 tax-free lump sum in a discretionary Linked Investment Platform, his or her net income would equal R51 756 or 22% more than he or she receives from the tax-free savings account per year, as he or she would get an interest income exemption of R34 500.
Financial gains
This example only shows the financial benefit of RAs over tax-free savings accounts in the first year of retirement, though in practice the gap will persist in future years.
Financial planners need to remind their clients of critical factors such as the lump sum tax-free allowance offered through RAs of up to R500 000 on retirement and of the primary plus secondary income tax rebate on RAs.
Beyond this, RAs are exempt from estate duty; something which does not apply to tax-free savings accounts and they offer clients protection from creditors, which is no small factor in today’s economic climate.
Although tax free returns and accessibility make the tax-free savings accounts an important part of an client’s holistic financial plan, the numbers show that RA’s are still the most appropriate vehicles for retirement savings.
