How much should I contribute to my Retirement Annuity?
Should I contribute to my RA? And if so, how much should I contribute? Should I try and maximise contributions to my RA and take advantage of the great tax breaks RAs have to offer? Or, should I invest it in a normal investment account, where I have more freedom?
In South Africa's first ever interactive RA guide, I will delve into this question. I will tell you what I like about them and what I do not like about RAs. Then, the age old question of "How much should I contribute to an RA?" will be answered by running interactive simulations. This will help me determine my ideal RA contribution.
The most important benefit of an RA
Want to pay less tax? Then contribute more to your RA. Retirement funds - which include RAs and pension funds - offer the greatest tax benefits. Period. There are other ways to reduce my tax bill - such as Tax Free Savings, Section 12J, investment properties - but none offer the kind of tax benefits that an RA gives me.
How is this done
I am allowed to deduct up to 27.5% of my salary - to a maximum of R350k per year - from my income.
The table below is a helpful one to see how much tax I can save due to contributions to an RA. (Use the slider to adjust it to your income)
Secondly, until I am retired, I will not be paying any income or CGT within my RA. Yes. It is all tax free growth within my RA until I retire.
But there are downsides to RAs
Stunted return prospects. RAs have to comply with something called Regulation 28. It is issued under the Pension Fund Act and limits the extent to which my money is allowed to be invested in risk assets. In South Africa’s case a maximum of 75% is allowed to be in equity. A maximum of 30% offshore. And a maximum of 25% in property.
Where is the downside you may ask? Time horizon is the most important factor in determining one’s asset allocation. Given my retirement is at least twenty years away, I would like to be invested in 100% equity. And have a lot more invested offshore than what the act prescribes. You see I have time in my hands to weather the storm of any short-term falls in the equity market. I would benefit in the long run , + twenty years , if my money was purely in equities. But no. The pension fund act limits my exposure to equities and offshore investments and thus my retirement fund’s ability to generate greater long-term returns.
Then there is the biggest downside to RAs. At retirement, I will need to convert at least two thirds of my RA into another annuity - either guaranteed - , living - or hybrid annuity. In 95% of cases, a living annuity is appropriate. Now, some good news. This money does not have to comply with Regulation 28. This means it is allowed to be invested in 100% equities, for example. (Side note - how is that for a paradox. Whilst I am young, my retirement funds need to comply with Reg 28 which limits my exposure to equities. However, once I am older and retired, my annuity does not have to comply with these strict limits). It is a good thing that my investments after retirement are allowed to be invested in risk assets and not comply with Regulation 28.
There is a big downside to living annuities. Any withdrawals from my annuity will be deemed as income and taxed at my then prevailing personal income tax rate. This is the worst kind of tax! So if I withdraw R30 000 per month, this is seen as a “salary” in the eyes of SARS and I am taxed accordingly. Compare this to a normal investment account. M withdrawals would be funded using dividends - local dividends are exempt (!!) from tax - and sales of assets, which would be subject to capital gains tax. A much lower form of tax.
The big BUT
There are lots of downsides to an RA, BUT the tax benefits of an RA are immense. The mere fact that I can deduct my RA contributions from my income will give my retirement savings an immediate boost equivalent to my marginal income tax rate. Where in the world do you get an immediate 30% (or whatever your marginal income tax rate is) boost to your returns. This is massive.
On the flip side, whilst there are great tax benefits pre-retirement, I know my retirement fund is likely to return less over the long-term compared to my normal investment account due to the regulatory investment restrictions put in place. Additionally, whilst tax savings are great pre retirement, it is the opposite once I hit retirement!
So should I invest more into my RA or invest the money into a normal invetment account? The only way to answer it is to run some numbers and simulations. Hey, I am a numbers guy. That is what is coming up in part 2. And it is interactive!