Maximising savings before tax season ends: RA or TFI?

Jeanette Marais, director of distribution and client service at Allan Gray.

As 29 February 2016 marks the end of the tax-year, taking advantage of tax breaks is a top-of-mind goal. There is still time to capitalise on the savings incentives instated by government. If making a decision between a unit trust-based retirement annuity (RA) or a unit-trust based tax-free investment (TFI), both of which offer tax incentives, which should you choose? Jeanette Marais, director of distribution and client service at Allan Gray, explains.

There has been much debate about the benefits of TFI products versus RAs. Both an RA account and a TFI savings product grow free of dividends tax, income tax on interest and capital gains tax.

By way of a simple example, if you save R2 500 per month for 16 years and eight months (the time it would take you to reach the R500 000 current lifetime cap in a TFI product) in an RA or TFI product, at the end of 30 years you could potentially end up with 45% more in your pocket than in a discretionary investment, because you are compounding all gains tax free*.

The main difference between the RA and TFI product is that an RA offers tax savings now, i.e. you pay less tax now because you make contributions with earnings on which you have not paid tax, but you will pay tax later, i.e. you defer paying tax. With TFI products, on the other hand, you use after-tax money to invest, but you pay no tax later; your withdrawals are completely tax free.

So which offers the best deal tax-wise?

Only 15% of non-retirement funding income is eligible for a tax deduction. This is set to change on 1 March 2016 to allow a tax deduction of up to the higher of 27.5% of taxable income or remuneration capped at R350 000 per year. This is a solid increase and will make the tax savings on an RA more relevant for higher income earners (albeit lower for the very high earners where the new annual rand cap is less than the previous 15% limit).

Apart from deferring tax in an RA, the tax saving comes from paying a lower average tax rate on the benefits withdrawn from the RA at and after retirement, versus the tax saved on contributions. The first R500 000 of any lump sum withdrawn from your RA is currently tax-free provided you have not taken previous withdrawals or retirement lump sum benefits. You can withdraw up to one-third, and the rest of the benefit must be transferred to an income-providing product, such as a living annuity or a guaranteed life annuity. When income tax is paid on this benefit, you are likely to be taxed at a lower rate than when you were making contributions, which is where the additional tax savings comes in.

Because of this, a disciplined investor paying income tax at marginal rate of 36% could pay more than 50% less tax on their retirement savings over their lifetime. When comparing to a TFI product, the difference is that you have a future tax liability, whereas in a TFI your tax would already have been paid, but at a higher rate.

What’s the catch?

While the tax benefits of the RA and TFI are clear, it’s important to be aware of the restrictions before making a decision. RAs are governed by the retirement fund regulations, specifically Regulation 28 of the Pension Funds Act, which limits the exposure you can have to more risky asset classes, such as equities and offshore investments.

In TFI products, there are no restrictions on asset classes but you can only invest in investments that charge fixed fees, which limits your selection. In addition, you can only invest R30 000 per year in TFI products. This is the maximum limit for all TFI accounts in your name, across product providers. If your goal is to save for retirement, the maximum annual contribution of R30 000 in a tax-free savings account may not be enough, and if you over-contribute SARS will penalise you at 40%.

Access to cash may be another deal breaker: your investments in an RA cannot be accessed before the age of 55. You can access your TFI investment at any time. However, withdrawing from a TFI account impacts negatively on your lifetime investment limit of R500 000 – you cannot replace money that you have withdrawn.

Which product wins?

For retirement savings, in most cases RAs offer the best tax deal, but you need to be able to live with the restrictions. For long-term discretionary investments, it probably makes sense to put your first R30 000 into a TFI product. However, you will only enjoy the long-term compounding benefits if you aren’t tempted to withdraw along the way.

As always, if you need help with choosing a product that is most appropriate for your goals and circumstances, we recommend you talk to a good, independent financial adviser.

Allan Gray launched its Tax-Free Balanced Fund in January 2016, accessible to investors via the company’s Tax-Free Investment Account. To read more, visit https://www.allangray.co.za/latest-insights/local-investing/launching-the-allan-gray-tax-free-balanced-fund/.

*Assuming a 13.3% total return, with the split between capital gains, interest and dividends based on the Allan Gray Balanced Fund’s track record.