One of the most attractive features of a retirement annuity (RA) is that a portion of your lump-sum payout is tax-free. For that reason, you may be tempted to cash in your RA as soon as the law allows, when you turn 55. But that isn't always the smart thing to do.
There is much debate and conflicting advice about when you should mature a retirement annuity. Some financial advisers say you should do it at the earliest possible date, while others urge you to hold out as long as you can.
In terms of current legislation, you may not cash in an RA before the age of 55 and you may not continue contributing to one beyond the age of 69. In effect, the South African Revenue Service (SARS) insists you become a pensioner by the time you turn 70, from which age SARS will not allow you to claim tax deductions on contributions to retirement savings.
The question of whether you should cash in an RA at 55 it essentially a tax issue because the tax-free amount has not changed in nominal terms for many years, which means inflation is steadily reducing its value in real terms.
But there are many other important factors to consider when deciding when to mature an RA.
1. Costs
Tiny Carroll, a senior legal analyst at Old Mutual's Fairbairn Capital, says many people forget about the costs involved in maturing an RA early to take advantage of the tax-free amount. There are disinvestment costs if a policy is matured before its actual maturity date (if you have chosen a maturity date later than age 55), which reduce the investment return on the RA. And then, if the after-tax lump sum and the annuity income (bought with at least two-thirds of the amount) are re-invested - usually in another policy - there are costs on the new investments themselves. These include the product provider's initial charges and the adviser's commissions.
"It costs money to move money," Carroll says.
2. Risk assurance
If you have death or disability assurance attached to your RA, you will lose the cover when you cash in your RA. At 55, life assurance cover is likely to be more expensive, depending on how the premiums are structured. If you are in poor health, you may no longer be able to get life assurance, there may be exclusions for certain conditions, and/or your premiums may be loaded.
3. A dumping ground
You may wish to use an RA to invest any other lump sums, to take advantage of the fact that contributions are tax-deductible and excess contributions over the tax limit can be rolled over to subsequent years. You could pick up a benefit from the number of years you have had the RA (see explanation below).
When you mature the RA, you will only pay tax at your average rate on the balance of the one-third lump sum after the tax-exempt level (R120 000 or R4 500 times the number of years that you have had the retirement savings investment). Note that this tax exemption is not specific to RAs. It applies to all retirement vehicles and applies only once per taxpayer.
If you invest additional money invested as a lump sum into your RA and this sum exceeds your allowable tax deduction for contributions for that year, the excess contribution may be rolled over to the next and subsequent years. If the amount is not used up during contributory years, it can be used to increase the tax-free portion of the lump sum. If the excess is still not used up, it can be deducted from your post-retirement income as if it where a current contribution.
4. Tax
There are five issues to consider in respect of RAs (and all other tax-incentivised retirement savings), because of the tax implications. The five issues are:
- Your contributions;
- The investment build up;
- The maturity of RAs;
- Post-retirement; and
- Your retirement savings when you die (whether you are still saving or drawing a compulsory annuity).
You need to consider all five issues together to ensure that what you do now does not negatively affect you at a later stage.
- Contributions
Your contributions to an RA are tax-deductible up to a maximum level. In other words, you can use money you would normally have had to give the taxman to boost your retirement savings.
The most that a taxpayer can claim in one year against income tax, in respect of RA contributions, is the greater of:
* 15 percent of non-retirement-funding taxable income; or
* R3 500 less allowable contributions to a pension fund; or
* R1 750.
If you are on the maximum marginal income tax bracket of 40 percent and 15 percent of your non-retirement-funding taxable income amounts to a contribution of R100 000 a year to an RA, you are in effect saving R40 000 a year in tax. You are investing the taxman's money and receiving a return on it.
- Investment build-up
* Income tax: The interest, foreign dividends and net rental income of property investments in the investment portfolio of an RA are taxed at a flat rate of 18 percent a year, whereas the income on the same investments in an individual life assurance policy are taxed at 30 percent a year. The life assurance companies pay taxes on both instruments on your behalf. With unit trusts, you pay tax on interest and foreign dividends above the tax-exempt limits at your marginal rate of income tax.
*Capital gains tax (CGT): No CGT is payable on capital gains made on tax-incentivised retirement savings. On the other hand, life assurance companies pay CGT on an annual basis on net capital gains made on individual life assurance investments at a flat rate of 7.5 percent. With unit trusts, you pay CGT on any capital gain made when you cash in your investment, less allowable deductions. (For example, the first R10 000 gain is not subject to CGT.)
- Maturity of an RA
When you mature an RA, you are permitted to take up to one-third as a lump sum, but you must use a minimum of two-thirds to purchase a monthly annuity (a pension), officially known as a compulsory purchase annuity.
Any lump sum you take is subject to tax, but with some exemptions.
The taxation of retirement fund lump sums is complex and involves two legs, namely:
* The initial exemption: The maximum tax-free amount is the greater amount of R120 000, or R4 500 multiplied by the number of years that you have been a member of the retirement fund.
You cannot stagger lump-sum benefits to claim the tax-exemption more than once. For example, if you received the R120 000 exemption allowed on a lump-sum benefit from your pension fund when you retired, you cannot again claim that benefit on the maturity of an RA. The exception is if you hold an RA for more than 26.6 years (the point at which R4 500 a year equals R120 000). From the 27th year, you can claim a further R4 500 for each year you hold the RA.
However, if you have a number of retirement savings vehicles that qualify for the lump-sum exemptions but no single vehicle meets the maximum claimable amount, you can claim a proportion of the tax benefit with each lump sum you take until you reach the maximum. When you mature a retirement savings vehicle, always take the full tax-free amount.
The formula used for calculating the tax-free amount of the one-third you can take as a lump sum is known as Formula B:
Formula B: Z = C + E - D
Z equals the tax-free amount.
C is a maximum of the greater of R120 000 or R4 500 multiplied by the number of years of membership of the RA fund.
E is any previously disallowed deductions for contributions made to a fund, or unclaimed contributions disallowed for RAs and pension and provident funds. Any contributions you make to a provident fund are "previously disallowed deductions" as you cannot claim them as a deduction against your taxable income in the years in which you make the contributions.
D is the total of tax-free portions of lump sums claimed from pension, provident and RA funds in previous years.
* The balance of the lump sum. Any amount of a lump sum you withdraw from your RA, after the tax-free portion, is taxed at your preferential average rate of taxation and not your higher marginal rate of tax. South Africa has what is called a progressive tax system, which means that you pay a higher rate of tax for each additional rand you earn above pre-selected taxable income levels. So, by averaging out the tax brackets, you pay less tax than you otherwise would have done.
For example, with an income of R270 001 a year you would be on the top marginal rate of 40 percent, but your average rate of taxation would be 28.91 percent. In other words, after averaging out all the amounts you pay in the various marginal rate tax brackets, you would pay R78 070 in tax (before rebates).
You can calculate your average rate by using the following equation: Take your total tax paid in a year and divide it by your annual taxable income, and multiply by 100.
- Post-retirement
Once you start drawing a pension from a compulsory purchase annuity bought with a minimum two-thirds of your RA, you will be subject to tax. Your pension will be taxed at your marginal rate of income tax with the normal exemptions and rebates applying.
- At death
If you have selected an annuity structure that allows for the continued payment of a pension or a capital payment to your heirs or dependants - for example, a living annuity - the amount will not become part of your estate for estate duty or CGT purposes.
The dilemma
Carroll says that many of the tax arguments used in favour of maturing an RA at age 55 are not properly analysed and the consequences are often not obvious.
At first glance, he says, a recommendation to mature an RA at 55 for tax reasons seems to make sense, especially when viewed in the light of the fact that the tax exemption on lump sums (the R120 000 or R4 500 x N formula) was last amended in 1986, more than 17 years ago. What was a substantial perk then has been eroded by inflation and is only worth R29 000, based on an average inflation rate of 8.02 percent, in real terms today. However, Carroll says other issues need to be taken into account. These include:
- If you remain in the portfolio for longer than 26 years, the R120 000 tax-free amount will increase by R4 500 a year in line with the R4 500 x N formula. The longer you are a member of the RA fund after 26 years, the greater the tax-free amount will be.
- The government has been steadily reducing personal income tax to cancel the effects of inflation on our tax tables. This has resulted in the level at which taxable income begins to be taxed at the maximum marginal rate being raised over time.
In recent years we have seen the maximum marginal income tax rate move down from 45 percent (which applied to every rand you earned over R80 000 a year) to a more favourable 40 percent (of every rand earned over R270 000 a year). This also has the effect of lowering your average rate of taxation
So, if you are taking the maximum one-third lump sum, the reduction of the real value of the R120 000 could at least partially be offset by the lower average rate of tax on any balance.
- Most retirees live on a fixed amount of capital and income, and their marginal rates of tax are lower after retirement than before retirement. In other words, if you mature your RA at 55 and take the maximum one-third, you could be on a much higher average rate of tax than you would be if you mature your RA when you are in retirement.
- The tax threshold for retirees over the age of 65 is being raised each year. For the 1997/98 tax years, persons over the age of 65 only became liable for tax once their taxable income exceeded R30 050. For the 2004/05 tax year it is R47 222.
When you consider that the first R16 000 of interest is exempt and that all medical expenses, including medical scheme contributions, are deductible, retirees may earn a gross income of more than R66 000 a year before any tax becomes payable, depending on their medical expenses. (The lowest average rate is equal to the current minimum marginal rate of 18 percent.)
Carroll says since there is a reasonable likelihood that a retiree could be taxed at a far lower marginal rate on the RA income than the rate at which he was able to deduct his contributions, the difference in tax rates will provide an additional investment advantage.
Estate duty
Carroll says the estate duty consequences should also be considered, since annuities provided by an RA are not subject to estate duty. (See case study opposite.)
In our case study, should Mr X die just after retirement, R538 500 (the maturity values of Policy 1, 2 and 3) will be subject to estate duty under Option 1 (if he matures his RA early), while R299 622 will be subject to estate duty under Option 2 (if he waits until he is 65 to mature his RA).
In other words, at current estate duty rates, early retirement will expose Mr X's capital to a further potential capital loss of R46 075, being 20 percent of the difference between R538 500 and R299 622.
Carroll says buying a living annuity with the proceeds of an RA after retirement can be likened to setting up an inter vivos trust.
The member will be able to select an income anywhere between five and 20 percent of the capital used to buy the annuity. On his or her death, the annuity income will be passed on to dependants or beneficiaries without any estate duty or executor's fees being levied.
Carroll says that in an environment which holds so many variables, many of which are positive for RA fund members, it would be imprudent to retire prematurely from an RA fund without a careful analysis of all the variables and how they apply to one's personal situation. He says the old carpenter's advice "to measure twice and cut once" can be applied equally to the decision to retire early from an RA.
"It is not in your interest to mature an RA early, merely to re-invest the proceeds in a similar investment vehicle," Carroll says.
What is a retirement annuity?
A retirement annuity (also known as an RA) is essentially an individual savings plan for retirement with tax advantages. An RA has a tax structure similar to a defined contribution pension fund, where at retirement you receive a lump sum, of which at least two-thirds must be used to purchase a pension (compulsory purchase annuity) for life.
RAs were introduced in South Africa in 1960 as a way to encourage self-employed people to make provision for retirement. An added advantage of an RA is that you can add life assurance and disability cover to the savings plan.
RAs are not restricted to self-employed people. They are often used by small- to medium-size businesses to provide retirement savings for employees, with the employer paying a portion of the contributions. The RA is in the name of the employee, and once money has been paid into the RA by the employer, it remains the property of the employee. People who are members of employer- or industry-sponsored retirement funds can also use RAs to top up their retirement savings.
The main features of RAs are:
1. RAs are structured in a similar way to a defined contribution pension fund. RA funds are administered by life assurance companies. They are effectively life assurance endowment policies with tax incentives. Every RA fund must have a board of trustees. The trustees are appointed by the life assurance company administering the fund.
2. Contributions to RAs are tax-deductible within certain limits.
3. Tax payable by you is deferred until the day you retire. When you retire, up to one-third of the benefit (less tax) may be taken in cash. At least two-thirds must be used to purchase an annuity (a monthly pension). There is tax paid on your behalf by the assurance company on interest, foreign dividends and net rental income. The current rate of taxation is 18 percent.
4. You cannot draw on, or surrender, an RA until you are 55, unless you become disabled. In other words, 55 is your earliest retirement date. You can extend your retirement date beyond 55, but you cannot access your money before you reach 55. If you stop paying your monthly contributions to an RA, the residual amount of money will remain invested until you are at least 55. You can increase and decrease your contributions to an RA.
5. You may not contribute to an RA past age 69.
6. Recently, life assurance companies have started offering a wide range of underlying investment choices, ranging from conservative to aggressive. Most of the underlying investment choices are in unit trust funds. However, you can also get risk-profiled investment portfolios put together by the company providing the RA, as well as capital-guaranteed, smoothed-bonus options.
7. Money paid into an RA is not counted as part of your estate if you go bankrupt, and your creditors cannot claim this money. This is very useful for people who run their own businesses or who provide personal security for a loan to a business. As a consequence, no money-lending institution will accept an RA as security against a loan.
8. You can take out life and disability assurance linked to an RA. If you are disabled before you retire from the fund, you will be paid a disability income until the benefits from the RA become due.
9. An RA fund is the same as any other retirement fund. It must have trustees who set the rules of the fund, ensuring the money in the fund is properly managed and that the benefits are correctly paid out. However, you have no say in the election or appointment of the trustees. The assurance company sponsoring the fund normally appoints the trustees.
10. You can nominate beneficiaries for the proceeds of an RA. However, the trustees of the RA fund do not have to accept the beneficiaries and must, in terms of the Pension Funds Act, ensure that dependants of the deceased RA fund member are taken care of. By naming beneficiaries, you prevent the money becoming part of your estate and being subject to executor's fees of 3.99 percent.
11. An annuity paid to beneficiaries on the death of the member is exempt from estate duty - a saving of 20 percent. The recipient, however, will pay tax on the income at their marginal rate of taxation.
A case study
Mr X took out an RA for a 25-year term when he was 40. That was 15 years ago. His monthly premium is R954. The projected growth rate on his RA is 10 percent a year. Now, at the age of 55, the value of the RA is just over R360 000. The question facing Mr X is whether he should mature his RA early (option 1) or wait until he is 65 (option 2).
Option 1
Lump sum
One-third cash: R120 000
Tax-free portion: R120 000
Tax payable: none
After-tax lump sum: R120 000
Annuity
Because Mr X has retired from his RA, he is compelled to take the remaining two-thirds in the form of an annuity. Assuming that he does not require the income at this stage, he decides to take a living annuity, and elects to take the minimum income allowable, which is currently five percent a year.
Note that for the purpose of this example, it is assumed that the portfolio underpinning the annuity will grow at 10 percent a year. But because five percent is being taken in the form of income, the fund value will grow by five percent a year. Mr X's income will, therefore, escalate by five percent a year.
Mr X now makes the following investments:
1. Policy 1: R572pm
Funded by the after-tax premium originally used to fund the RA from which he has now retired. Invested for 10 years to mature at age 65.
Maturity value of Policy 1: R108 400
2. Policy 2: R120 000
He uses the after-tax lump sum from the RA to invest as a single premium for 10 years.
Maturity value of Policy 2: R292 600
3. Compulsory annuity
He uses R240 000 to buy an annuity. The fund value increases by 5 percent a year after income has been extracted from the fund.
Fund value at age 65 will be: R367 500
4. Policy 3: R600pm
Mr X's "unwanted" stream of annuity income (from an early-matured RA) is invested after tax in a second pure endowment policy. This premium will escalate by 5 percent a year in line with the net increase in the underlying portfolio. The investment term is 10 years.
Maturity value of Policy 3: R137 500
Option 2
Mr X elects to continue as a member of his existing RA to age 65. His premium of R954 a month continues to be tax-deductible in full.
Capital available at retirement
Option 1
Maturity values
Policy 1: R108 400
Policy 2: R292 600
Policy 3: R137 500
Annuity portfolio: R367 500
Total retirement capital at 65: R906 000
Option 2
RA maturity value: R1 117 900
One-third lump sum: R372 633
Tax-free amount: R120 000
Taxable portion: R252 633
Less tax (at 28.9%): R73 011
After-tax lump sum: R299 622
Capital to purchase annuity: R754 266
Total after-tax capital available at age 65:
If you take early retirement: R906 000
If you maintain your RA: R1 044 888
In this case, by maturing his RA at 55, Mr X would have made a loss of R138 888.
Assumptions made for the purposes of this example:
1. Marginal rate of tax: 40 percent throughout.
2. Average rate of tax 28.9 percent throughout.
3. Policy maturity values projected at 10 percent. Costs of six percent of each premium. Obviously, costs will vary depending on the circumstances. It is however important to take these costs into account and not to follow quotes blindly.
4. RA maturity values projected at 10 percent.
This article was first published in Personal Finance magazine, 3rd Quarter 2004. See what's in our latest issue