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:
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.
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 MBA CFP ® is an independent financial adviser who helps people put investment and risk structures in place to live wonderful lives. You can contact him on 082 856 0348 or at Financialwellnesscoach.co.za. Please send your questions to kenny.meiring@sfpwealth.co.za