Other than the obvious merits of providing an income upon retirement, retirement annuities (RAs) are also one of the most tax efficient investments. Over the last few years RAs have received some bad publicity for the way they are administered. If you unpack the criticism, however, you will see that much of it is based on how a company structures its RA product as opposed to how a generic RA works.
Recent articles have dealt with unjust penalties and fees associated with certain companies’ RAs. Recent cases referred to the ombud show that penalties of up to 30% of the fund value can be and often are imposed on an RA fund member if they wish to alter, cancel or transfer their RA to another insurer. Fortunately, Treasury’s recently released retirement reform papers make it clear that it seeks to address this and prevent the industry from charging excessive fees and penalties (see our previous article, Retirement Reform: Proposal on Costs).
Most unit trust companies made a decision some time ago not to charge initial fees (management fees) or penalty fees. Nedgroup Investments, as an example, does not charge an initial management fee, nor are there any penalty fees if a fund member chooses to transfer their fund value to another insurer. Instead Nedgroup Investments applies an ongoing management fee depending on the underlying funds chosen.
From a tax point of view, it is hard to find another financial product that comes close in terms of return on investment. An RA member can deduct tax on their contributions of up to 15% of their non-pensionable income. This deduction will increase for the majority of South Africans if Treasury’s latest proposals are promulgated (see our previous article on retirement reform).
Assuming a client has a tax rate of 40% this would essentially mean that SARS will be subsidising up to R400 of a R1000 contribution to an RA. If the same client chose to invest in a bank call account or endowment instead, the client would effectively be paying tax on the R1000 first (up to 40%) and the after tax amount (between R600 and R1000) would go into the bank call account or endowment. It is difficult to achieve a return that matches the saving on tax of an RA, never mind the actual returns on the underlying funds.
Another tax advantage is that there is no tax payable on the growth of an RA. Tax on the interest and dividends is now exempt as is any capital gains tax within the portfolio. Compare this to an endowment where there is tax “within the fund” in terms of the four fund approach*. Any tax saved “within the fund” has the net effect of increasing your investment returns as they are “re-invested” within your portfolio.
Any income received from a compulsory annuity will be taxed at your marginal rate of tax. If a linked life annuity is selected, the member has the option of receiving income of between 2.5% -17.5% per annum. You are therefore also able to administer your income received in terms of need as well as tax.
Admittedly, endowments pay out their entire benefit tax-free; but remember that the investor would not have had the benefit of receiving returns on the tax saved on their contributions and “within the fund”.
One of the biggest advantages of an RA which is often overlooked is the fact that it can be used as an efficient estate planning tool. Due to the fact that the death benefits on an RA go straight to your identified dependants, no executor’s fees should be levied on an RA death benefit. This means a saving of up to 3.99% of the death benefit. There is also no capital gains tax payable on an RA when either the member or his/her dependant receives any benefit.
Lastly, there is no longer any estate duty payable on the death benefit of an RA, which is another significant tax advantage. Estate duty is tax payable on your death of certain assets that you have accumulated. Assuming that you have a house, endowment, money, etc. to the value of R10 000 000, potentially up to R2 000 0000 (20%) will be payable to SARS in the form of estate duty. As of January 2009, SARS has scrapped estate duty on any approved retirement fund which includes RAs. R10 000 000 sitting in an RA will thus not attract estate duty in terms of this exemption.
Obviously one should not simply invest in an RA for tax reasons and the client’s overall needs should be considered. But if used for the correct reasons, an RA can be an effective tool for estate planning.
RAs can be accessed by fund members on retirement, death, disability, formal emigration as well as if the fund value is below R7000.
Other than the tax advantages mentioned above, RAs have many other investment advantages. These should be discussed with your financial planner.
* In terms of the Income Tax Act growth on investments owned by individuals, companies as well as corporates in an endowment will be taxed in terms of the so called four fund approach. All interest and net rental income will be taxed at 30% in the individual policyholder fund and 28% in the companies and corporate policyholder’s fund. Capital gains will be taxed at an effective rate of 9.99% and 18.648% respectively. The tax levied will depend upon the type of assets class invested in. This taxation process takes place at the insurer and places no tax responsibility on the investor.