Despite the tax benefits on retirement contributions and the tax free growth, the fact that pension income benefits are ultimately taxed has led people to question whether saving in a retirement fund really is better than making your own retirement savings arrangements with after-tax earnings.
One of the main ways government encourages people to save for retirement is to offer tax deductions on saving in an approved retirement fund. While this tax relief can be very helpful when you’re working and contributing to a retirement savings fund, the benefits that you eventually receive from your retirement fund when you stop working are still taxed.
To help South Africans make informed retirement saving decisions, Old Mutual Corporate Consultants conducted a thorough investigation into how tax impacts retirement outcomes. The analysis aimed to compare the tax impact of various vehicles to save for retirement. The three vehicles considered were a retirement fund, discretionary savings, i.e. using after tax income, and finally a Tax Free Savings Account (TFSA).
Five different scenarios (using different combinations of these three vehicles) were compared:
Scenario 1: Discretionary savings only (Discretionary)
Scenario 2: Discretionary savings, but including saving in a Tax Free Savings Account (Discretionary TFSA)
Scenario 3: Saving in an approved retirement vehicle (Retirement)
Scenario 4: Saving in an approved retirement vehicle and also reinvesting any tax savings on a discretionary basis (Retirement Plus)
Scenario 5: Saving in an approved retirement vehicle, and reinvesting any tax savings in a Tax Free Savings Account as well as in a fully taxed, discretionary vehicle (Retirement Plus TFSA)
The analysis also considered different levels of income, because the impact of tax depends on how much you earn. “People who earn higher salaries pay more tax, which means the different tax treatment of the savings vehicles result in more significant impacts for higher income earners,” explains Andrew Davison, Head of Advice at Old Mutual Corporate Consultants.
Three levels of pre-tax income were compared: R20 000 per month, R60 000 per month and R120 000 per month.
In all five scenarios, and across all three income levels, the full impact of tax (both before and after retirement) was modelled to compare the impact over the lifetime of an individual. This required some important assumptions, including that the tax regime would remain the same as now, adjusting limits and caps by inflation where appropriate.
Davison says the analysis provided some valuable insights. As expected, it emphatically shows that the Retirement scenario (scenario 3) provides the best outcome in terms of income after tax, both before and during retirement. The difference is significant. Based on the same level of take-home pay before retirement, the Retirement scenario provides an after-tax pension that is just over double the income under the Discretionary scenario (scenario 1).
By contrast, the Discretionary scenario provides the worst retirement outcome across all three income levels. “This is because the additional tax being paid on your salary, due to not benefiting from retirement contribution tax deductions, leaves relatively little money over to make a substantial post-tax contribution to discretionary retirement savings,” he says, adding that the difference was more evident at higher income levels.
Although the Retirement Plus scenario (scenario 4) also produces a much better outcome than the Discretionary scenario, Davison says it still did not quite match up to the pure Retirement scenario. “For a person earning a R60 000 per month gross salary, it provides an after-tax pension that is 75% higher than under the Discretionary scenario, compared to an extra 102% in the Retirement scenario.”
“Introducing a Tax Free Savings Account does improve the outcomes of both the Discretionary TFSA (scenario 2) and the Retirement Plus TFSA (scenario 5), but they still fall short of the Retirement scenario (scenario 3),” he adds. This is because the Tax Free Savings Accounts only provide tax relief on growth and there are limits on contributions, so the benefit is limited.
Interestingly, across all income levels, the Retirement scenario produces a net replacement ratio (that is the ratio of income after tax in the year after retirement date, to the salary after tax just before retirement) of about 100%. This is based on savings of 15% of salary and a 40-year working career lasting for 25 years in retirement. “This demonstrates that a suitable and diligent long-term savings plan can deliver a sound retirement outcome.”
When evaluating these options, however, Davison points out that there are a number of factors that need to be considered - only one of which is the impact of tax. “That said, taxation is an important factor and it is useful to look at the full impact the various savings approaches could have on your current take-home pay as well as on your retirement benefit one day,” he concludes.
The following important assumptions were used in the analysis:
We considered the impact of taxation over a person’s full working lifetime as well as their retirement. (This meant assuming that the average person will start work at age 25, retire at age 65, and live to age 90.)
To simplify the calculations, we assumed that salaries increase in line with inflation.
This allowed us to make the important assumption that future National Annual Budgets will ensure that tax bracket creep is fully adjusted in line with inflation and that all rand amounts, in terms of tax thresholds, caps and limits, will also be adjusted in line with inflation. Of course, this is a reasonable expectation, but is by no means a certainty. If South Africa’s fiscal situation comes under pressure at any point, it is possible that the Budget will fail to make these adjustments fully as this will allow government to derive some additional tax revenue, as has been the case at times in the past. The one exception in terms of this assumption is that we assumed that the interest exemption (both primary and secondary) is not adjusted for inflation as that is the stated intention of National Treasury (it has been replaced by Tax Free Savings Accounts).
The calculations used the tax rates, exemptions and limits applicable for the2018/19 tax year. Allowance was made for all taxes and thresholds such as interest exemptions and capital gains tax exclusions. Capital gains were assumed to be realised each year.
Annual investment growth was assumed to be 4% above inflation after fees, split between interest & rental income, dividends and capital gains. This applied to both pre-retirement and post-retirement. The same net-of-fees return was assumed for retirement and discretionary savings, so no allowance was made for any differential in fees.
About Old Mutual Corporate:
Old Mutual Corporate is a leading South African provider of retirement fund solutions through their award-winning umbrella platform, pre & post retirement investments, group risk solutions, financial education, and balance sheet solutions, including a holistic consulting capability through Old Mutual Corporate Consultants. These are provided to a broad range of public and private organisations and institutions from SMEs to large corporates. Visit http://www.oldmutual.co.za/corporate for more information.