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Topping up your retirement annuity

10 February 2015 Hugo Malherbe, PPS
Hugo Malherbe, Product Development Executive at PPS Investments.

Hugo Malherbe, Product Development Executive at PPS Investments.

When, why and how?

Have you ever wondered why, at this time of the year, you receive a plethora of emails from investment businesses recommending that you top up your retirement annuity (RA)? The short answer is that the 2014/15 tax year closes on 28 February and you’re able to reap significant tax advantages by making an additional RA contribution before the tax year-end.

Generally speaking, an additional investment into an RA is beneficial provided that you have not yet reached your maximum tax deductible retirement annuity contribution for the year and provided that all money returned from SARS in future is reinvested into your RA portfolio. By making an additional contribution to your RA before the end of the current tax year:

1. You can boost your tax return

A portion of the total contribution you make towards your RA in any given tax year is tax deductible. This means that when submitting your income tax return, you can claim back a portion of the money you have contributed towards your RA.

To maximise your tax benefits:

a) It may be beneficial to top up your retirement annuity to the maximum tax deductible amount at the end of the tax year.
b) If you choose to reinvest the money that you are able to reclaim into your retirement annuity, you are further able to add to your retirement savings without any additional outlay.

2. You can get further tax breaks

Returns generated within retirement annuities are not subject to income tax, Capital Gains Tax (levied on profits resulting from the sale of assets such as property or units in a unit trust) or Dividend Withholding Tax (tax levied on dividends received). RAs therefore offer a welcome tax break from the outset.

Let’s use a fictional character called Emma to illustrate the merits of investing R20 000 in an RA versus a unit trust:

MEET EMMA

• AGE: 40
• INVESTMENT AMOUNT: LUMP SUM: R20 000
• PLANNED RETIREMENT AGE: 65
• CURRENT SALARY: R550 000 per year
• REVIEWS HER PORTFOLIO: Annually

In this scenario, if Emma were to top up her retirement annuity at the end of the tax year, using the R20 000 lump sum she has available, she will receive approximately R7 600 back from the tax man, which she can reinvest in her RA or use as disposable income. If she invests the same R20 000 into a unit trust, she will not be eligible to reclaim.

We’ve illustrated three investment scenarios and the value of a R20 000 lump sum investment upon retirement (in real terms and accounting for the corrosive impact of inflation):

OPTION A:

Emma places her R20 000 into an RA and reinvests the tax deduction
The value of her lump sum at retirement will be R53 036

OPTION B:

Emma places her R20 000 into an RA and keeps the tax deduction as disposable income. The value of her lump sum at retirement will be R39 317 + (R7 600 disposable income).

OPTION C:

Emma places her R20 000 into a direct unit trust investment. The value of her lump sum at retirement will be R42 433.

Assumptions for Emma’s investment scenario:

• 12%: The annual market return at the time (100% equity allocation allowed.)
• 10%: The annual return from an RA portfolio with a 75% equity allocation (the maximum allowed by Regulation 28 of the Pension Funds Act).
• 6%: Inflation per annum
• 0.5%: Ongoing administration and advice fees of per annum respectively across both the equity and Regulation 28 compliant portfolios
• 30%: Dividend component assumed in equity return (30% of returns will be taxed at 15% DWT)
• 15%: Dividend Withholding Tax assumed at this amount
*Note that tax tables are adjusted for annual inflation, annual CGT exclusion threshold is excluded from the calculation and all gains, in this scenario, are realised in full each year-end.

Why are there different outcomes?

The different investment outcomes result due to two factors:

1. Access to additional investment capital

The contribution to a retirement annuity boosted the amount Emma was able to reclaim from tax, which provided her with the additional investment capital which provided the potential to generate higher returns.

2. Tax breaks are applied to the RA, but not the equity portfolio

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 Emma invested in an equity portfolio for example, she would have been subject to DWT at 15% on all dividends received, as well as to CGT when switching between different unit trusts. However, a pure equity portfolio could potentially generate higher nominal returns before tax.

What if Emma has already reached her maximum tax deductible contribution?

Once her maximum tax deductible contribution has been reached, and provided that she is comfortable with the heightened risk that accompanies a full equity portfolio, it is generally preferable for her to consider an equity investment as a solution. (It may still be advisable to transfer these accumulated savings into an RA in future, in a year during which she does not reach her maximum tax deductible contribution.)

Retirement annuity contributions for the tax year ending 28 February are tax deductible for the greater of:

• 15% of non-retirement funding taxable income (income not already being used for contributions to a pension or provident fund);
• R3 500 less current pension fund contributions; or
• R1 750 - with any excess being carried forward to the following year of assessment. (Certain specific exclusions by the South African Revenue Service [SARS] may also apply).

Remember, when making any investment decision, an investor’s individual risk profile and personal investment objectives need to be evaluated, and the provision of quality financial advice may be of great assistance when doing so.

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