CAPE TOWN – In this advice column Robin Gibson from Harvard House answers a question from a reader who wants advice on when to use a retirement annuity and when to use a tax free savings account.
Q: With the introduction of tax free savings accounts, I’m thinking of changing how I save for retirement. Should I split my monthly contributions between a retirement annuity and a tax free account? I know there are limits on how much you can put into a tax free account, but it does allow me to be more aggressive and invest 100% in equities. What is the best way to make use of these new accounts?
To start with, it is important to note the specific differences between a retirement annuity (RA) and a tax free savings account (TFSA). The following table may be useful as a quick reference:
|Retirement Annuity (RA)||Tax Free Savings Account (TFSA)|
|Contribution Deductible||Yes – may be used to reduce taxable income||No – Only after tax money may be invested|
|Contribution Limits||Yes – The greater of 15% of non-pensionable income or R3 500 less current Pension Fund contributions or R1 750||Yes – R30 000 Annual Limit
R500 000 Overall Lifetime Limit
|Capital Gains Tax (CGT)||No||No|
|Tax on interest||No||No|
|Dividends Witholding Tax (DWT)||No||No|
|Portfolio Limitations||Yes – governed by Regulation 28. Maximum of 75% in equities||No asset class limitation. Certain investment vehicles excluded. Can be 100% in equities|
|Unlimited Withdrawal||No – limited to a maximum of one third cash after age 55, balance must by some form of lifelong pension||Yes – any time|
|Withdrawals Tax Free||No – lumpsum taxable after a lifetime limit of R500 000 and pension fully taxable||Yes – all withdrawals free of any tax|
So what are the main reasons to consider a TFSA?
The first would be to replace the interest exemption in our tax laws. Treasury specifically stated that with the introduction of the TFSA they will not increase the annual interest exemption in future. It is currently R34 500 for individuals over 65, and R23 800 for everyone else.
This represents the interest on an investment of roughly R575 000 at 6% for over-65s and R396 000 for those under 65. Since many retirees used this interest exemption to minimise tax in retirement, a TFSA becomes the alternative.
The second major reason to use a TFSA is for the capital gains tax (CGT) exemption. This addresses the erosion of value every investor faces when they convert their growth asset to an income-producing asset.
For example, let us assume you have built a portfolio of high growth, low interest unit trusts. You reach retirement and now wish to restructure your investment to produce higher income, possibly by switching to high paying dividend funds and property funds.
Such a switch would generally create a CGT liability and lead to an erosion of the absolute income that could be generated by the portfolio. Using this approach in a TFSA will certainly pay handsomely in the long term.
It is also important to note that in our experience as executors of estates, even the smallest of estates seem to pay CGT. Thus an element of your investment base that is free of CGT in your estate can be very meaningful to your heirs.
The third benefit of TFSAs is that they can create tax-free income. The way our tax legislation is written, income from different places combines to create an escalating tax liability.
For example someone may have a pension, rental income, interest from a bank deposit and some part time employment. Each of these may be under the threshold in their own right, but when combined they create a tax liability that reduces the individual’s disposable income. Consequently, any investment that can create a tax-free revenue stream has to be very attractive.
Overall, there are scenarios where a TFSA would add value to your retirement, and some where it would not. To try to keep things simple, I would consider the following questions in order to assess where a TFSA may be of benefit to you. If you are unsure, engage with a professional adviser for more clarity.
|Question||If the answer is yes||If the answer is No|
|Q1: Am I retired?||Proceed to Question 2||Proceed to Question 3|
|Q2: Do my investments create a tax liability?||A TFSA may be a very appropriate vehicle to convert your Investment into a more tax efficient one.||Proceed to Question 3|
|Q3: Am I investing for growth||The ability to reduce CGT in the long term has to be attractive. To spend any of your investments, you have to sell them, this triggers a CGT event. A TFSA is worthy of consideration.||Given the path you travelled to get to this block, a TFSA may be of little value to you.|