Weighing up the pros and cons of RAs and tax-free investments

Question

I pay tax at the 45% marginal rate and want to invest R3,000 a month for the next 10 years. Should I use a retirement annuity (RA) or a tax-free investment for my savings? I do not own any tax-free or retirement investments.

Answer

It depends on what is more important to you – flexibility or tax efficiency.

The tax-free investment option

Tax-free investments are appealing because of their simplicity. All the growth is free of tax. Withdrawals are not taxed. There are no access restrictions and no future tax consequences to manage. Unlike retirement investments, tax-free investments are not subject to Regulation 28, which gives you more investment freedom and, potentially, higher long-term returns. The main limitation is the contribution cap of R36,000 per year, with a lifetime limit of R500,000.

The RA option

RAs offer a benefit that no tax-free investment can replicate: the upfront tax deduction. Contributions to an RA are deductible up to 27.5% of your taxable income. For an individual paying tax at 45%, this represents a significant immediate saving.

Like tax-free investments, RAs grow free of income tax, dividends tax and capital gains tax. However, access to the funds is restricted until you reach the age of 55.

At retirement, up to one-third may be taken as a lump sum, subject to the retirement lump-sum tax table, and the remaining two-thirds must be used to purchase an annuity. Income drawn from that annuity is taxable.

These restrictions should not be ignored. The question is whether the tax benefit compensates for them. The example below should help quantify the benefit.

A contribution of R3,000 per month equals R36,000 per year, or R360,000 over 10 years before growth. Assume a tax-free investment earns 10% per year due to the absence of Regulation 28 limits, and an RA earns a more conservative 8% per year. After 10 years, the outcomes can be seen in the table below.

We need to account for the tax saving that you get with the RA premiums. At a marginal tax rate of 45%, contributing R3,000 per month to an RA generates a tax saving of R1,350 a month, or R16,200 a year. Over 10 years, the cumulative tax saving is R162,000.

If these annual tax savings are invested separately into a tax-free investment at a 10% annual return, they grow to approximately R260,000 over the same period.

Comparing the outcomes

Option 1: Tax-free investment only. Value after 10 years: about R620,000. All proceeds are tax-free and can be accessed at any time, either as an income stream or through ad hoc lump-sum withdrawals.

Option 2: RA with tax savings reinvested. Total value after 10 years: about R810,000. This consists of an RA value of about R550,000, of which one-third (R183,333) may be taken as a lump sum at retirement, likely falling within the tax-free portion of the retirement lump-sum table, and two-thirds (R366,667) must be used to purchase an annuity.

In addition, the accumulated value of the tax savings invested over the period amounts to about R260,000 in a tax-free investment.

This results in a total tax-free lump sum of roughly R443,000, with the same flexibility as a tax-free investment, plus an annuity of R366,667. At a 5% drawdown rate, this annuity would provide an income of about R18,000 per year, taxed at the marginal rate applicable at the time.

Which option produces the better outcome?

At its core, this is a trade-off between tax efficiency and ease of access. This is summarised in the table above.

A tax-free investment offers maximum flexibility, while an RA restricts access in exchange for a powerful upfront tax saving that, when reinvested, can materially improve the long-term outcome for high-income earners. DM

This story first appeared in our weekly DM168 newspaper, available countrywide for R35.