Anyone who earns an income can use a retirement annuity (RA) to provide for their retirement.
When you take out an RA, you become a member of a retirement fund. You pay contributions to the fund, which are tax-deductible within limits. Your contributions are invested to earn returns that will grow your savings.
Retirement funds are regulated by the Pension Funds Act, and each fund also has its own rules, which govern members and trustees and the service providers they appoint, such as the fund administrator.
The Income Tax Act defines an RA. It stipulates that you cannot access your savings in the fund before the age of 55, unless you are in ill health and need to retire early.
It also states that when you, as an RA fund member, retire, you are allowed to receive up to one-third of your savings in cash, but you have to buy a pension with the balance.
If your RA is underwritten (see below) it will also be regulated by the Long Term Insurance Act.
RAs were originally introduced in South Africa in 1960 to provide self-employed people with a retirement-savings product that had tax incentives similar to those enjoyed by members of employer-sponsored retirement funds.
Many employers make it compulsory for employees to contribute to an employer-sponsored fund. In most cases, this means you will enjoy the benefit of contributions made by your employer, and the fund’s life and disability cover could cost you less than if you took out assurance as an individual.
In addition, the costs on an employer-sponsored fund may be lower than those on an RA, but not always – you need to find out.
Remember, however, that the contributions to employer-sponsored funds are often based only on your basic salary, and they may exclude other forms of remuneration, such as a travel allowance, bonus, commissions or share options.
If your employer-sponsored fund does not accept voluntary top-up contributions, you can top up your retirement savings by making contributions to an RA from your non-pension-funding income.
You can claim as a tax-deduction a percentage of your RA contributions made from your non-pension-funding income (see “The tax benefits of using an RA to save”, below).
TYPES OF RA ON THE MARKET
There are two main types of RAs in South Africa:
* Underwritten, or life assurance, RAs; and
* Non-underwritten, or non-life assurance, RAs.
Non-life assurance RAs are typically provided by unit trust companies, companies known as linked-investment services providers (or Lisps), which provide a platform on which you can buy unit trust funds and exchange traded funds (ETFs), and providers of index-tracking investments.
In the case of an underwritten RA, all the investments are made within a life assurance investment policy, typically owned by the fund.
The terms of the policy contract (see “Contractual obligations”, below) may not be in your interests if, in future, you find you are unable to continue contributing to the fund.
RA funds have different types of underlying investment portfolios, and you need to consider the type of portfolio that will be most appropriate to your needs.
Underwritten RAs invest in life assurance portfolios or unit trust funds. Some life assurers offer portfolios in which the returns from investments are “smoothed” – that is, some returns are withheld in years when markets perform well to pay you better returns when markets perform poorly.
Some life assurers offer RA portfolios with guarantees, so that you have more certainty about the returns your retirement savings will earn.
Lisps offer you a wide choice of unit trust funds and possibly ETFs and shares.
Unit trust companies may offer RAs that invest in their own funds or in both their own funds and funds of other asset managers.
RAs that invest in low-cost index-tracking investments may invest in an index-tracking portfolio, ETFs or unit trusts that track indices.
In the past, life assurance RAs were often combined with life cover, which can provide for your family if you die before retirement. However, most RAs sold now do not include this cover.
CONTRACTUAL OBLIGATIONS
RAs offered by life assurers typically have a contract that binds you to contributing a certain amount for a certain period. This is also the case with some Lisps.
Your contract may state that the contributions will increase by a certain percentage each year, in order to keep pace with inflation.
Remember that, although you cannot withdraw what you have saved in an RA before age 55, you are not obliged to sign a contract to contribute until you are 55.
Ideally, you should not bind yourself to paying contributions and increases on those contributions when you cannot be sure you will be able to adhere to the contract for its entire duration – if you lose your job, for example, you may be unable to keep up the contributions.
However,
regardless of whether you have a contribution term or not, you should aim to contribute to an RA for as long as possible to maximise your income in retirement – and that means long after age 55.
In 2008, the restriction on the age after which you could no longer belong to an RA fund – 69 years – was removed, and you can now take out and belong to an RA fund at any age, regardless of when you retire. This allows you the opportunity to use an RA to your advantage in your retirement tax planning.
If you are not happy with your RA provider, you can switch to another provider, but if you have a life assurance RA, watch out for a penalty – what life companies call a “causal event” charge – if you have not fulfilled your contract.
Your RA has to comply with the Pension Funds Act, including regulation 28, which stipulates the maximum amounts that can be invested in the different asset classes. This restriction is aimed at ensuring that your investments are well diversified and that your investment risk is reduced. For example, a retirement fund may not invest more than 75 percent in equities; listed property may not make up more than 25 percent of the portfolio; and offshore securities may not exceed 25 percent of the fund.
RA providers usually require a minimum lump sum of R50 000 or monthly contribution of R500 or R1 000, but some will accept as little as R12 000 or R200 a month.
ADVANTAGES OF AN RA
* The contributions are tax-deductible.
* Your savings are not taxed while they are in the fund.
* There are tax concessions on the lump sum withdrawn at retirement (see “The tax benefits of using an RA to save”, below).
* If you change jobs, you can keep your RA and continue or stop contributing. The tax deductions you enjoy may change if you join a new fund with a new employer. There may be penalties on a life assurance RA if you stop or reduce contributions.
* You can transfer savings in an employer-sponsored retirement fund to an RA fund when you leave your job.
* You can transfer your savings from one RA provider to another. However, if the RA is underwritten, the life assurer may impose a penalty (see below). A transfer will require an application for a section 14 transfer under the Pension Funds Act. Make sure you are aware of all the costs you may incur when you switch (see “Costs on your RA”, below.)
* Your savings are safe from your creditors should you be declared insolvent. A creditor can only claim the money if you withdraw a lump sum at retirement and you receive it in your bank account.
* Your savings can be shared with a former spouse on divorce, but only if this is agreed in a court-approved divorce order.
* Your savings will not form part of your estate if you die before retirement, which means no estate duty. The trustees of your fund will distribute your savings to your dependants and any beneficiaries you nominate at their discretion. If you die without dependants or nominated beneficiaries, the money will be paid into your estate.
DISADVANTAGES OF AN RA
* You cannot access your savings until you turn 55, even if you lose your job. You can access your savings before 55 only if you emigrate, are forced to retire due to ill health, or you stop your contributions and your total savings amount to less than R7 000.
* Some RAs have high charges that may significantly reduce your income in retirement. A one-percent reduction in fees can add 30 percent to your savings over 40 years.
* If you have an underwritten RA, whereby you pay contributions for a contracted period, the life assurer may impose a penalty if you stop or reduce your contributions, or if you transfer your savings to another RA provider. The penalties are imposed to, within certain limits, recover commissions paid to advisers and costs that would have been recovered over the full period.
THE TAX BENEFITS OF USING AN RA TO SAVE
If you save for your retirement in a retirement annuity (RA), the tax advantages can enhance your savings by 30 percent over 40 years, one RA provider says. Here are the tax benefits of which you should be aware:
Tax savings on your contributions to an RA
You can claim a tax deduction, within limits, for contributions made to an RA. You can claim the greater of:
* 15 percent of any taxable income you earn (before deductions) that exceeds the income on which your pension or provident fund contributions are based. In other words, if you are self-employed and do not belong to a pension or provident fund, 15 percent of your taxable income. Or, if you pay contributions to a pension or provident fund that are based on your basic salary and you receive other remuneration (for example, a year-end bonus) that is excluded when your contributions are calculated, 15 percent of your non-pensionable salary. Or, if all your salary is pensionable but you also earn rental income or overtime pay, for example, 15 percent of the taxable rental income or overtime pay.
* R3 500 minus your current contributions to a pension fund.
* R1 750.
If your contribution exceeds the greater of the three limits outlined above, the South African Revenue Service will roll over the contributions to following years and you may claim them in future tax years.
Contributions exceeding the tax deductions that you do not manage to claim in future years can be offset tax-free at retirement against your one-third lump sum. If the over-contributions are not fully deductible at that stage, they can also be offset against your pension income, making the pension tax-free until it is fully deducted.
It is expected that the way the tax deductions are calculated will change from March 1, 2016. If the changes are implemented as expected, as of that date:
* If your employer contributes to your RA fund or to a group life scheme on your behalf, both of these contributions will be added to your income as a fringe benefit, increasing your taxable income.
* You will be able to add both your contributions and your employer’s contributions and deduct the total from the greater of your taxable income or remuneration, up to 27.5 percent of your income or R350 000 a year, whichever is lower.
* Contributions that exceed these limits can be rolled over to subsequent years and claimed as a deduction in years in which your claim is less than the maximum. If you claim the maximum each year until you retire, the contributions that exceed the limit can be deducted at or in retirement.
When you contribute to an RA, you essentially defer paying tax on what you contribute until you withdraw your savings in retirement. Deferring tax in this way is likely to work in your favour if you earn a high income before retirement but will earn less as a pension when you retire. This is because your marginal rate, and thereforeyour effective income tax rate, will be higher when you are working than it will be when you are a pensioner.
Your tax savings will also grow tax-free in the RA (see below).
Tax savings on your investments in an RA
The interest, dividends and rental income that your RA savings earn are not subject to income tax or dividends tax. Any capital gains your investments make will not be subject to capital gains tax. These tax breaks can make a big difference between what your savings in an ordinary (discretionary) investment earn and what your savings in a retirement fund (including an RA) earn, because with the latter, you earn returns on the full, untaxed amount invested.
Reduced tax on your savings when you retire
When you retire, you can take up to one-third of your savings as a cash lump sum. The first R500 000 of this lump sum will be tax-free if you have neither retired from another retirement fund nor withdrawn money from any retirement fund.
If you retired from a fund previously, the tax-free amount you withdrew then will be offset against the R500 000. In other words, the R500 000 tax-free amount applies once, regardless of the number of funds from which you retire.
If you made a pre-retirement withdrawal, that withdrawal may be partially or fully offset against the R500 000 tax-free amount.
Amounts higher than R500 000 are taxed as follows:
* R500 001 to R700 000: 18 percent.
* R700 001 to R1 050 000: 27 percent.
* More than R1 050 000: 36 percent.
You may join as many RA funds as you like. However, the tax-free portion takes into account your savings in all of your retirement funds. You cannot apply it to each retirement savings product.
The two-thirds of your savings with which you must buy a pension will not be taxed on the date of your retirement; you will pay tax, at your marginal rate, on your pension income as you receive it. As a result, you may well be taxed on your savings – which earn tax-free growth – at a lower rate than the rate at which your savings would have been taxed before you retired. This is because:
* Your income in retirement is typically lower than it is while you are working;
* Over-65s enjoy higher tax rebates; and
* You defer paying tax until you receive the pension.
COSTS ON YOUR RA
You may be charged the following on your retirement annuity (RA):
* Commissions or advice fees. You may pay commission on a life assurance RA, although the Financial Services Board has announced its intention to put a stop to commission on new policies in the future and to replace these with advice fees.
You pay commission as an ongoing charge. However, the life assurer may have paid your adviser or broker upfront for signing you up for an RA, and the payment will be based on the length of the contract. The life assurer recovers the upfront commission over the term of the policy. If you stop or reduce your contributions before the end of the contract term, the life assurer will charge you a penalty to recover the commission it has already paid.
If you take out a unit trust RA through a financial adviser, you will probably pay your adviser an advice fee, which may be deducted from your contributions when you pay them and from your savings. The ongoing annual fee on your assets is typically capped at 1.14 percent (including VAT), but you can negotiate a lower fee with your adviser and you can stop paying it if you believe your adviser is no longer providing you with sound advice. Make sure you know what the fee will be in rands, rather than as a percentage only.
* Administration fees.
* Life assurance policy fees.
* Asset management fees. You may pay these fees directly to the RA provider if it is managing the investment portfolio. If the underlying investments are in other companies’ funds (such as exchange traded funds or unit trusts), you may pay the asset management fees charged by these companies.
Asset management fees may include performance fees, which depend on the return earned by the fund, and you need to understand what these fees could amount to.
Managers have largely abandoned charging upfront investment fees – most charge only annual management fees.
* Lisp fees. If your RA is provided by a linked-investment services provider (Lisp), you may be charged an annual fee for using the Lisp’s investment platform.