Piru Harington, our Head of Operations, recently realized he was missing out on tax benefits by prioritizing his TFSA over his RA contributions. He crunched the numbers and found that, depending on your tax bracket, contributing to an RA could significantly boost your long-term returns.When Tax Free Savings Accounts (TFSA) were introduced almost a decade ago, it was hard to believe that the Government could be that charitable in allowing a South African investor the opportunity to invest tax free. What if I told you there’s another opportunity for tax incentives that’s been hiding in plain sight all along?
If you’ve been saving for retirement, which we all should and only some have, and you’ve been doing it in your TFSA account alone, then listen up, you may want to learn about the tax benefits of a retirement annuity.
First, let’s do a quick high-level recap, a Retirement Annuity (RA) is an investment vehicle that gives you access to diversified investment opportunities (think Regulation 28) which offers significant tax benefits such as deductions on contributions and tax-free growth within the fund. The annual tax deductible limits are the lesser of 27.5% of your taxable income or R350 000.00.
A Tax Free Savings Account (TFSA) is an investment account in which you can invest up to R36 000 per year (with a lifetime limit of R500 000) without paying tax on interest, dividends, or capital gains. Anything in that account is yours, and the Taxman can not lay their hands on any of it.
But there’s one important distinction to make: TFSA contributions are after tax money and contributions into RAs are tax deductible.
Let’s break it down with an example. Suppose you earn R50 000 per month, which totals R600 000 per year. This places you in the fourth SARS tax bracket, where you’ll pay R121 475 plus 36% on taxable income above R512 800. After rebates, this amounts to R135 632 in taxes, giving you an effective tax rate of 22.61% (R135 632 divided by R600 000).
Now, let’s say you have R1 000 to invest. With a TFSA, you deposit R1 000 directly and invest it according to your risk appetite. Simple enough, but remember, this is after tax money.
With an RA, however, you can invest up to R1 562.50, and SARS effectively refunds you R562.50 when you file your tax return. So, net on net, you’ve invested R1 000 in after-tax money into the RA.
Assuming both investments grow at 10% per year for 30 years. At the end of this period:
- Your TFSA grows to R17 449.40.
- Your RA grows to R27 264.69.
But remember - RA withdrawals are taxable. Applying your effective tax rate* of 22.61%, your RA balance after tax is R21 101.42. Despite this, your RA still outperforms the TFSA by a significant 20.93%.
In summary, when you contribute to an RA, you’re getting a tax break at your top marginal rate (some people as high as 45%), which is the highest percentage of tax you pay on your income. However, when you retire and start drawing from your RA, you’re likely to be taxed at your effective tax rate, which is the average rate across all your income. For most people, this effective tax rate is significantly lower than their marginal rate during their working years. This difference in tax rates effectively lets you save more upfront and pay less later, giving your retirement savings a significant boost.
So bottom-line, if you’re in tax bracket 2 or higher, a TFSA could be a good addition to your RA, but it might be worth maxing out your RA contributions first. Otherwise, you could be leaving retirement money on the table.
*Assumption that you stay in the same tax bracket at retirement as when you made the contribution – which normally isn’t the case as you’re normally in a lower one.
This article is for informational purposes only and does not constitute financial, tax, or legal advice. Readers should consult a qualified professional, such as a financial advisor or tax consultant, before making any financial or investment decisions based on the content provided. The examples and calculations are for illustrative purposes only and may not reflect individual circumstances or specific tax situations.
The tax-related information is based on current South African tax laws, which may change over time. Investment decisions should be made with careful consideration of personal financial goals and risk tolerance, as all investments carry inherent risks, including potential loss of principal. EasyEquities disclaims any liability for actions taken based on this article’s content, and readers are encouraged to seek professional advice before proceeding with any financial decisions.
