179 – How to decide between a retirement annuity and a tax-free investment

by | Nov 20, 2024 | Financial Planning, Investment, Retirement, Tax

Question

I am 55 years old and was thinking of increasing my pension fund contribution at work to 15% from 10%. But having read your article, is it not a better idea to invest the 5% in a tax-free investment until retirement? I have never had one before and neither has my wife.

Answer

This is a really interesting question and in truth, there is no straightforward answer as the right solution will depend on your personal circumstances. I will flesh out the key features of both the products so that you can be in a better position to make the right call. 

Investments

The retirement annuity is constrained by regulation 28 which restricts the amount that you can invest offshore and in equities. At the moment, the house views of many of the better financial planning houses is not out of line with regulation 28. We are, for example, anticipating better growth in the local market than offshore over the next year so the offshore restriction of 45% is not really a factor.

Tax on Growth The growth in both investments will not attract income tax so there’s no difference on that front.

Tax on premiums The real difference comes with the way the premiums and proceeds are treated. With the retirement annuity, your premium comes off your taxable income there is an immediate tax saving.

For example, if your tax rate is 30% and you want to invest R 36,000 into a retirement annuity, once you take the tax discount into account, you would actually be investing R51 429 into a retirement annuity. 

There is no tax break on the premiums that you pay into a tax free investment.

I ran a comparison are you investing an after tax amount of R36,000 a year into a retirement annuity as well as into a tax free investment.  I assumed that the tax rate would be 30% and that the investment would grow by 10% a year.  We had the following results: 

Amount invested each year Value at end of year 1 Value at end of year 5 Value at end of year 10
RA investment of R36k after tax discount R51,429 R56,571 R313,977 R819,639
Tax free investment R36,000 R39,600 R219,784 R573,747

On the surface, it looks like the RA is way better than a tax free investment.  However, there are a couple of variables that could change matters: 

  • Your tax rate

 If you have a low tax rate, the additional investment amount that you get because of the tax saving will be lower so the gap between the two investments will be small.  This is why I generally prefer to use a tax free investment for a person starting out on their investment journey. 

  • The expected returns

 There will be times when the constraints of regulation 28 will result in weaker performance.  If the tax free investment gives a return that is 2% more than the RA, then its value would be R922k after 10 years which is bigger than the R819k from the RA.

Tax on proceeds

This is where the tax free investment comes into its own.

You do not pay any tax on the proceeds so you can effectively use it to draw a tax free income.  This is extremely valuable when it comes to structuring your retirement income in a tax efficient manner.

With a retirement annuity, you are obliged to use 2/3 of the proceeds as an income. This income will be taxable in your hands. I noted that your wife does not have a tax free investment.  If she is likely to have a lower tax rate than you when you retire, it may be an idea to invest some of the additional funds in her name.

So, to summarize, there is no easy answer here as it does depend on the current investment environment, and your tax rate. I would recommend that you speak to a financial advisor who can help you make the right decision.

KENNY MEIRING IS AN INDEPENDENT FINANCIAL ADVISER

Contact him via phone, email or via contact phone on the financialwellnesscoach.co.za website

Read more of our articles on the Daily Maverick website or newspaper weekly!

Dec 02 2024

189 – Retirement and risk cover options for employees

Question I have a business with 20 employees.  I would like to put in some kind of retirement fund for them.  Is this financially feasible for our sized company? If so,...
Dec 02 2024

188 – Finding the right annuity for you takes thought

Question I recently heard someone talking about a with profit annuity.  I only know about living annuities and guaranteed life annuities.  How does a with-profit...
Dec 02 2024

187 – What to do if you get retrenched

Question I have just been retrenched and I'm feeling quite overwhelmed by all the decisions that I need to make.  Do you have any suggestions on what the big pitfalls...
Dec 02 2024

186 – Making the most of a medical aid on a budget

Question I would like to join a medical aid after not being on one for the past two years.  I’m 39 with a young child and can only pay around R3 500 a month. I’m...
Dec 02 2024

185 – To quell chaos, your business needs its own will

Question I recently heard someone talking about a will for a business. How does this work?Answer A will for a business documents what should happen to your interest in...
Dec 02 2024

184 – Products that can give employees peace of mind

Question A colleague has recently been diagnosed with cancer. He is going to be unable to work properly for at least three months.  The company will pay him his basic...
Dec 02 2024

183 – Measures to take to ensure that your offshore assets are protected

Question A friend’s husband passed away earlier this year, and the executor says it will take at least three years for his estate to be wound up because he owns shares...
Nov 20 2024

120 – The new two pot retirement fund

Question I retired three years ago, with half my income coming from my company pension fund and the other half from interest from investments. I am paying tax at a rate...
Nov 20 2024

121 – Why you should have separate offshore wills

Question I retired three years ago, with half my income coming from my company pension fund and the other half from interest from investments. I am paying tax at a rate...
Nov 20 2024

122 – How utilising a living annuity can maximise the financial health of your heirs

Question I retired three years ago, with half my income coming from my company pension fund and the other half from interest from investments. I am paying tax at a rate...

Download the Life File