Saving for retirement: Does the RA trump all?

RA contributions for the tax year February 2014 are tax deductible for the greater of 15% of non-retirement funding income (income not already being used for individual or company contributions to a pension or provident fund), R3,500 less pension fund contributions or R1,750 (certain specific exclusions by the South African Revenue Service [SARS] may also apply).

 

This unique feature has positioned the RA as the retirement savings vehicle of choice for most investors. However, due to the limitations placed by Regulation 28 of the Pension Funds Act (which restricts the equity allocation of an RA portfolio to a maximum of 75%), some investors feel that an unrestricted investment may allow for greater savings at the point of retirement. Based on the fact that pure equity investments have historically outperformed mixed asset class investments over the long term, these investors argue that the additional returns generated from an equity investment may be significant enough to offset the tax benefits an RA offers.

 

So which should be the preferred course of action if you have a lump sum to put towards your retirement: An ad hoc investment into an RA or into a unit trust that invests 100% in equities?

 

Let’s consider a 40-year-old investor who plans to retire at 65 and has R20 000 available to invest. All else being equal, if a pure equity portfolio outperforms a high-equity, Regulation 28 compliant portfolio by 2.5% p.a. but our investor reinvests all tax deductible RA contributions back into her RA portfolio, the value of her R20 000 upon retirement (after accounting for inflation) is set out below.

 

We’ve reflected the potential outcomes for three different scenarios: An investment into an RA which will be tax deductible, an investment into an RA which will not be tax deductible (as the investor has already contributed her maximum tax deductible amount for the year) and a direct investment into an equity unit trust.

 

 

 

Our investor earns an annual salary of R550 000, which is likely to rise with inflation. Typically, she’ll review her investment portfolio on an annual basis and make changes to the selection of underlying unit trusts comprising her investments once a year.

 

We’ve based our calculation on an annual market (pure equity) return of 10.5%. A dividend component of 50% has been assumed and Dividend Withholding Tax has been reckoned at 15%. Capital gains are realised in full each year-end and the annual Capital Gains Tax exclusion threshold has been excluded from the calculation.

 

We’ve assumed an annual return of 8% from an RA portfolio with a 75% equity allocation (the maximum allowed by Regulation 28 of the Pension Funds Act). Tax tables have been adjusted for annual inflation.

 

 

The different investment outcomes result due to several factors. Firstly, had this contribution been able to boost the amount our investor was able to reclaim from tax, she would have had access to additional investment capital which would have provided the potential to generate higher returns. Secondly, an RA provides a number of additional tax benefits, as all returns are exempt from income tax, capital gains tax (CGT) and Dividend Withholding Tax (DWT). Had she invested in an equity portfolio, our investor would have been subject to DWT at 15% on all dividends received, as well as to CGT when switching between different unit trusts. However, she would also have generated higher nominal returns.

 

This illustrates that should you have an additional amount available to invest, a contribution to your RA is likely to be favourable – provided that you have not yet reached your maximum tax deductible contribution and plan to reinvest all money claimed back from SARS into your RA portfolio. It is further likely that the value proposition most RA investors are able to access will be enhanced even more, as National Treasury has indicated its intention to allow for potentially greater tax deductions from the 2013/2014 tax year.