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How tax changes affect your retirement planning

27 July 2012 John Kinsley, MD of Unit Trusts at Prudential Portfolio Managers

In an article published in a financial magazine shortly after the delivery of the annual budget speech, a respected local economist made the comment “…essentially this was not a good budget for the saver…”. But is this really the case? Not necessarily, sa

The most important tax changes for future retirees relate to capital gains and dividends

The two tax changes that are particularly relevant are:

1. An increase in Capital Gains Tax for the individual from 10% to 13.3%.

2. The introduction of a Dividend Withholding Tax of 15% on all dividends paid to South African individuals.

Investing in a government-approved retirement fund versus a balanced unit trust has different pros and cons

To really see how these changes affect your retirement planning, we will use a case study of a 35-year old individual who wishes to retire at the age of 60 and can afford to set aside R2500 each month towards retirement. Also, whereas most analysis focus only on the build-up phase (before retirement), we will also take into account the actual retirement phase.

The table below summarises the differences between investing in a retirement annuity versus investing in a balanced unit trust as an individual:

Where you invest your money

Option 1

Government-approved retirement annuity (RA)

Option 2

Balanced unit trust

Is your money invested pre- or post-tax?

Pre-tax

Post-tax

Advantage

You qualify for the RA tax deduction, which means you can invest the full R2500 each month.

Because you are not ‘locked-in’ to a product and any changes to regulations governing retirement funds does not concern you, you have more independence.

Disadvantage

Because your money is in an approved vehicle, you have limited access to and control over your money.

Because you will be investing post-tax money, and assuming a tax rate of 35%, you will be able to invest only R1625 of the available R2500.

The tax changes have different implications for the returns on different savings mechanisms

To illustrate the impact of the tax changes on the returns of these two savings options, we’ll assume the targeted return for both options is inflation plus 5% after investment management fees of 1% per year, and that inflation is 6%.

The two tax changes mean the following in our practical example:

1. For the individual investor (option 2) dividends will be taxed at 15%, while in a RA (option 1) there is no tax on dividends.

2. For the individual investor (option 2), any interest above the exemption level will be taxed as income – we assume an average rate of 35% – while in an RA there is no tax on interest.

This difference in tax means that the effective return for the RA (option 1) is 11% per year, while for option 2, it drops to 10.5% per year.

A seemingly small impact on returns can make a significant difference in the long run

“Even though 0.5% might not seem like a big difference, the compounding of this differential over many years will have a big impact on how much savings you, and your dependants, have at and during retirement,” explains John.

Focusing on the first two phases of the retirement cycle, the figures in the tables and the chart below show exactly to what extent the different tax treatments of options 1 and 2 impact returns over the long term.

1. The build-up phase: The value of your savings at retirement

Assumptions

Option 1

Government-approved retirement annuity (RA)

Option 2

Balanced unit trust

The fund has been allowed to build up over 25 years (age 35 to 60).

(Our earlier assumptions about returns and inflation also still hold.)

 

Retirement value

R3.9 million

Retirement value

R2.4 million

2. The retirement phase: Your monthly retirement income and your portfolio value when you pass away

Assumptions

Option 1

Government-approved retirement annuity (RA)

Option 2

Balanced unit trust

You need to draw R30 000 per month before tax from the age of 60 to live comfortably.

You can place the full amount in a living annuity, which means you will now pay tax on the monthly annuity amount.

Monthly income (after tax)

R19 500 per month

You can sell units in your fund for the value of R19 500. There is no income tax implication (although there could be a small Capital Gains Tax liability).

Monthly income

R19 500 per month

Your retirement phase lasts 20 years and you pass away at 80

End value of portfolio

R9.2 million

End value of portfolio

R3.2 million

 

In the third phase where the surviving spouse continues to draw the same income based on the same assumptions for another ten years, the difference between the final portfolio values of the two options becomes even more marked.

 (Click on image to enlarge)

Investors should decide what their priorities are when it comes to retirement savings and make an informed decision

Investors have different circumstances and views, and some may regard having more control over their money, as in the case of investing in a balanced unit trust, as essential. The final decision will always remain a personal one, but the numbers certainly do tell a story that is worth considering.

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