THE IMPACT OF TAX ON RETIREMENT-FUND PENSIONERS

Conventional wisdom, backed by National Treasury policy, would have you believe that saving in a retirement fund is the best route to saving for retirement. But this view downplays the effect of tax on the resulting pensions, which can be “punitive”.

Martin Hesse reports

AT PERSONAL FINANCE we have always advocated saving for retirement primarily in a retirement fund. This is because of the substantial tax concessions you receive, which you do not get with discretionary savings.

First and foremost, contributions up to 27.5% of your annual taxable income are fully tax-deductible to a maximum of R350 000 a year, and anything above that can be rolled over to a subsequent tax year or even used to reduce your tax liability on retirement.

Second, there is no tax on the retirement fund investment itself: no tax on interest, no dividends tax and no tax on capital gains (CGT).

You need to buy a pension with twothirds of your savings on retirement, of which the first R550 000 is tax-free. (This was increased from R500 000 for the 2023/24 tax year. The studies below use the old amount.)

Your pension is taxed as income. However, the prevailing view in the retirement industry is that this tax on your pension works out to be relatively low and is a small price to pay for the pre-retirement benefits.

But a financial planner and author on money matters has recently challenged this view, arguing that the tax you pay on your pension has a significant impact on your finances in retirement. It may actually outweigh the pre-retirement concessions, and, in certain circumstances, your outcome may be better if you avoided saving in a retirement fund altogether.

In a recent article, “Reducing tax before and after retirement”, Wynand Gouws, a Certified Financial Planner at Gradidge Mahura Investments, compared various retirement saving scenarios after having done the necessary calculations for a client.

“The conventional way of only looking at the pre-retirement tax savings is fundamentally flawed, and not enough time is spent on considering the postretirement impact of using retirement funds. Even though a retirement annuity (or contributing to a pension or provident fund) is extremely tax efficient before retirement, they are punitive post retirement, as all the post-retirement income is taxable,” Gouws says.

Gouws’s client was a young doctor of 34. He was earning R1.2 million a year and wanted to save the maximum 27.5% of his income (R330 000) towards his retirement at age 64. Thus he would be saving for 30 years. He had the following investment options: discretionary investments in the form of a unit trust portfolio and a tax-free savings account (TFSA), a retirement fund investment in the form of a retirement annuity (RA), or a combination of these. While Gouws provided various investment-combination scenarios, this article singles out the two that best demonstrate the fundamental differences of the contrasting approaches:

Scenario A: the client is fully invested in the discretionary unit trust portfolio plus a TFSA to the maximum allowed.

Scenario B: the client is fully invested in the RA, and invests the tax savings on his deductions in a discretionary portfolio and a TFSA to the maximum allowed.

Gouws’s assumptions, some of which were not detailed in the article, but which he provided to Personal Finance, were:

• Income (and contributions) increase annually by an assumed inflation rate of 6%.

• Taxes are according to the 2022/23 SARS tax tables and are assumed to adjust in line with the inflation rate annually over the planning period.

• Discretionary investments are in a unit trust portfolio, but with R36 000 a year invested in a tax-free-savings account up to the R500 000 lifetime maximum.

• The discretionary portfolio, a worldwide flexible fund, returns 11.41% a year, on average, which represents a real (afterinflation) return of 5.41%. The income after retirement is withdrawn from this portfolio (and the tax-free savings). CGT on these withdrawals has been accounted for, as has interest generated from these investments (which are added to taxable income, less the annual exemption).

• The RA portfolio is a Regulation-28compliant high-equity multi-asset portfolio. Regulation 28 portfolios are limited to 75% exposure to equities and 40% to offshore investments. Because of these limitations, the return is lower than the worldwide flexible portfolio: 10.81% a year, on average, which represents a real return of 4.81%.

Investment taxes do not apply.

• In both scenarios, the client remains in the same portfolio after retirement as before retirement, though in Scenario B it is in a living annuity wrapper. In Scenario A the TFSA and discretionary investment is now used for income.

• In both scenarios, no allowance has been made for a lump-sum withdrawal at retirement. The entire amount is used to provide an income.

• Both scenarios aim to deliver an income of 75% of the pre-retirement income. At retirement the client draws 5% of his savings for an annual income, increasing the rand amount annually by 5%. In Scenario B, the pension income is taxed, subject to secondary and tertiary rebates for pensioners at ages 65 and 75. In Scenario A, the income is drawn from the discretionary investment portfolio. Capital gains tax on withdrawals has been accounted for, as has tax on interest generated from the portfolio.

• Investments costs have been factored into the analysis, including an effective annual cost of 1.15% pre and post retirement. This takes account of administration fees and potential advice fees (0.5% each, annually).

As can be seen from Table 1, although the accumulated amount at retirement is about 25% higher in Scenario B, the sustainable income is considerably lower owing to the large difference in post-retirement taxes. In Scenario A the retiree pays about 12% in investment taxes. The Scenario B retiree pays about 29% tax in total, the bulk of which is income tax on the living annuity.

Considering the situation of a lower earner, Personal Finance asked Gouws to do the calculations for someone earning R720 000 a year, also saving 27.5% of his/her income annually.

The results were more equal (see Table 2), but nonetheless gave the Scenario A investor a slightly higher sustainable income in retirement.

To my mind, the issue boils down to this: how much more do you need to have saved in a retirement fund compared with a discretionary investment to offset the postretirement tax differences? This obviously depends on how long you live, as a longer retirement means you’re paying tax for longer, but let’s retain Gouws’s assumption that you plan to live to age 90. It also depends on your tax bracket in retirement.

In Gouws’s R60 000-a-month example, where the sustainable incomes differ by only 6% in favour of Scenario A, the savings at 64 (at present-day values) differ by about 19% in favour of Scenario B. So it would not take too much more in Scenario B to close the income gap to zero.

In the R100 000-a-month example, the savings at 64 differ by about 24% in favour of Scenario B, whereas the sustainable income figures differ by about 15% in favour of Scenario A. So here, the difference would need to be considerably greater.

Other studies

I refer now to two studies done on the benefits of using retirement funds to save for retirement. They focus on the differences in pre-retirement savings: one was by Alexander Forbes (now Alexforbes), the other one by Ninety One.

The Alexforbes study, undertaken a few years ago by leading Alexforbes actuary John Anderson and his team, was the subject of an article in this magazine (“Why saving in a retirement fund is hard to beat”, PF 1st quarter 2021.)

It compared saving in a local Regulation-28 compliant retirement fund with saving in discretionary funds under various investment and return scenarios. The assumptions differed from Gouws’s assumptions in that the savings would be for 35 years (not 30 years), and contributions would be 15% of income (not 27.5%). The tax refunds on contributions into a retirement fund would be reinvested.

If the two portfolios delivered the same pre-tax annualised real returns of 5.6%:

• Someone earning R500 000 a year would have accumulated R3 894 510 in a discretionary investment against R7 322 294 in a retirement fund. This is 88% more.

• Someone earning R1 000 000 a year would have accumulated R6 540 833 in a discretionary investment against R14 644 588 in a retirement fund, or 124% more.

Interestingly, the higher earner benefited more from saving in a retirement fund than the lower earner, the opposite of Gouws’s outcome.

Another, very recent, study, published in January this year, by product specialist

Marc Lindley at Ninety One, showed the difference of investing over 15 years in the Ninety One Opportunity Fund between an RA investment and a discretionary investment.

Investor A invests R10 000 a month into an RA, escalating at 5% a year. His tax bracket is 45%, so he receives a tax rebate of R4 500 on his contributions. Thus he is effectively investing only R5 500 a month from post-tax income.

Investor B invests a post-tax amount of R5 500 a month into a discretionary portfolio, also escalating at 5% a year. So the effect on his pocket is the same as Investor A.

After 15 years, Investor A has saved R4.8 million (at an annualised rate of about 8.5%), whereas Investor B has saved just over half of that: R2.5 million at an annualised rate of about 7.7%. The almost one percentage point difference in returns is attributable to investment taxes in the discretionary investment.

So who is right?

Gouws used a very specific example, where the investor invests the maximum 27.5%. He also assumed a slightly higher return on the discretionary investment, whereas the other studies compared investments with similar pre-tax returns.

While the added rebates for pensioners have been factored in, another tax advantage for over-65s is that they can claim all their medical expenses as opposed to a portion of them, and these tend to rise significantly in later life.

This means that, ultimately, considering all the variables, you need to do the sums yourself with your own financial adviser, to work out the best route for you.

The significance of Gouws’s work is that he shows that post-retirement taxes cannot be swept under the carpet, as those focusing on pre-retirement savings have tended to do.

He writes: “The analysis reinforces the importance of understanding tax preand post-retirement and implementing a retirement strategy that provides diversified income after retirement that specifically optimises for tax. This is even more relevant in a world where increased longevity results in people living into their 90s and 100s.

“We would argue that investors need to implement a diversified post retirement income strategy, this needs to be implemented 20 or 30 years before retirement. Such a strategy needs to consider the other benefits that retirement funds provide, including the fact that retirement funds are not included in your estate and reduce your estate duty; are protected against creditors and there are no executors’ fees on retirement assets.”