Marc Lindley | Retirement Annuities: the season of opportunity

The period following the festive season to the end of the tax year known as ‘RA season’ is probably the busiest time in the calendar year for the platform industry. Marc Lindley, product specialist on the Ninety One Investment Platform team, reflects on the many benefits that retirement annuities (RAs) offer investors.

A gift from me to me

The deductibility of contributions to an RA (subject to certain limits) can help ensure that a smaller portion of an individual’s total earnings is taxed by the South African Revenue Service. Current legislation allows for a maximum retirement fund deduction of the lesser of R350,000; 27.5% of the greater of remuneration or taxable income; or taxable income before the inclusion of any taxable capital gain. Therefore, to calculate the maximum tax-deductible RA contribution, other retirement fund contributions must be considered and deducted from the total maximum calculated. The subsequent tax saving received in respect of RA contributions can be re-invested in the RA. This ensures that the full gross contribution value is employed in the retirement vehicle.

To demonstrate the benefit this provides, we have compared the effect of taking a pre-tax amount of R10 000 per month from a salary and investing it in an RA versus a discretionary investment.

Essentially, for a taxpayer whose marginal tax rate is 45%, a discretionary investment only receives R5 500 for every R10 000 that can be invested into an RA because the discretionary investment can only be made with after-tax monies. The RA’s extra contribution value can be seen as a free ‘gift from me to me’, or from the taxman, depending on how you prefer to look at it.

Compound growth on the additional capital provides a material advantage and the longer the investment time horizon, the bigger this advantage becomes. Secondly, once invested, there is no tax on the growth within the RA. The discretionary investment, however, is subject to tax on the income portion of the return and capital gains tax on any disposals that are made, including switches, which serves to reduce the value of the investment. Figure 1 demonstrates the combined benefit of these tax savings over time for RA investors.

Source: Morningstar and Ninety One, performance NAV to NAV net of fees, as at 30.11.2023.*

Maximising the value received by dependents on death

As Figure 1 shows, the RA provides a tax-efficient vehicle that can maximise the value available at retirement to convert into an annuity. It also provides considerable estate planning benefits as any lump sums or annuities received by dependents on death are exempt from estate duty, capital gains tax and executor fees. However, any remaining previous contributions which did not rank for deduction (‘disallowed contributions’ or ‘DCs’), made after 1 March 2016, can be dutiable in the RA investor’s estate.

A beneficiary can choose to take the benefit as cash or in the form of a compulsory annuity (or a combination of the two). When taking the benefit in cash, the lump sum is taxed according to the retirement tax tables in the hands of the deceased, considering previous lump sums received by the deceased. This may reduce the value of the benefit received. Any DCs remaining for the deceased will be deducted (and will therefore be free of retirement tax) before the retirement tax tables are applied. The DC portion will however be subject to estate duty.

Where a beneficiary chooses to take the benefit as an annuity, they can receive the benefit without any retirement tax being deducted and without creating an estate duty liability. Even though annuity income is taxed at the beneficiary’s marginal rate, this allows preservation of a more significant portion of the death benefit while also providing a supplementary income.

Disallowed contributions present an opportunity

The cap on deductibility of contributions at R350 000 p.a. poses a challenge for high-net-worth individuals. After all, retirement funds are designed as tax-efficient savings vehicles, helping individuals to replace their income when they retire. For many wealthy individuals the tax-deductible portion of their retirement fund contribution has declined materially due to the R350 000 cap. However, it is important that these individuals save beyond the R350 000 limit p.a. to ensure that they can meet their monthly expenses from their savings when they reach retirement. Tax-free savings accounts (TFSAs) can help to cover some of the savings shortfall. However, the annual allowance of R36 000 may not be enough to close the deficit entirely. Rather than investing the shortfall in a voluntary investment, an alternative could be to allocate to an RA instead, even though the annual maximum deductible contribution of R350 000 has already been reached.

The over-contribution builds up a balance of DCs over time and this strategy can provide key benefits:

• No tax on the subsequent growth within the RA, whereas a voluntary investment would be subject to income and capital gains tax.
• If the DCs remain at retirement, they can be used to potentially increase the tax-free portion of the retirement lump sum.
• If a smaller or no lump sum is required at retirement, any remaining balance of DCs can be used to reduce or even neutralise the income tax paid on living annuity incomes received after retirement.
• While the contribution value of DCs is estate dutiable (where the beneficiary takes the benefit as cash), the growth on them is not. DCs can therefore serve to reduce the total amount of estate duty payable on death when compared to a voluntary investment, where the capital plus the growth is estate dutiable.
• As annuity income is received after retirement, the value of the DCs reduces, thus reducing the estate duty consequences.

Compelling benefits

While RAs involve some compromises – such as access to savings only allowed from age 55 and Regulation 28 investment restrictions – investors enjoy some compelling benefits. Besides the tax savings outlined above, RAs also allow individuals to diversify their retirement fund portfolio by providing access to a broader range of unit trust funds than an occupational fund typically allows. An RA therefore provides the opportunity to top up retirement savings in line with the maximum tax deduction which legislation allows.

Investors in RAs can retire at any time after the age of 55 but are not compelled to do so. If required, multiple RA contracts can be used to provide the opportunity to stagger retirement, which is useful if an individual embarks on a second career late in life. For instance, an individual can delay retirement from an RA while drawing an income from a compulsory annuity purchased with the retirement benefit of an occupational fund. Voluntary investments can further supplement an individual’s income while they stagger their retirement. Careful planning around staggering retirement can therefore help improve sustainability of capital and potentially reduce estate duty on total assets.

*The illustration is based on the performance of Ninety One Opportunity A class: R10 000 per month invested in the RA, R5 500 per month in the discretionary investment, both escalating at 5% p.a. The assumption is that the R10 000 RA contribution falls within the investor’s allowable deduction for retirement fund contributions. It’s assumed that 20% of the return is of an income nature and taxed at 45% for the discretionary investment and that the annual interest exemption has been used elsewhere. No disposals during the term are shown.

*Marc Lindley is Product Specialist on the Ninety One Investment Platform.