TFSAs - maximising retirement income, minimising estate duty

Paul Hutchinson, encourages financial advisors to carefully consider, not only the tax benefits, but all the financial, retirement and estate planning benefits that TFSAs provide.

Jan 13, 2020

6 minutes

Paul Hutchinson, encourages financial advisors to carefully consider, not only the tax benefits, but all the financial, retirement and estate planning benefits that TFSAs provide.

Tax free savings accounts (TFSAs) are a great initiative from government to encourage savings in South Africa. Jaco van Tonder, Advisor Services Director, has previously discussed how to maximise the value of the TFSA tax benefits, which are well documented. You pay no tax on dividends and interest received, and no tax on capital growth. As a result, you benefit from increased compounding of returns. Jaco’s article shows that after 20 years, TFSA investors realise an additional 20% return due to these tax benefits. But little continues to be said about the potential retirement and estate planning tax benefits.

The first choices

Anyone retiring from a provident, pension, provident preservation, pension preservation or retirement annuity fund needs to decide what portion of their retirement benefits they would like paid out as a cash lump sum.

  • Provident and provident preservation fund members can currently1 elect to have their entire retirement benefits paid out as a cash lump sum.
  • Pension, pension preservation and retirement annuity fund members can elect to have up to a third of their retirement benefits paid out as a cash lump sum.

Where there is a balance remaining, this must be used to purchase an annuity, either a guaranteed or living annuity, which pays a monthly income that is taxable at the annuitant’s marginal tax rate.

How can a TFSA help reduce this potential income tax liability?

A TFSA can help a retiring member who has chosen a living annuity reduce their marginal tax rate, hence maximise their after-tax income.

A living annuity is a compulsory purchase annuity offered by insurers, retirement funds and linked investment service providers under which the income is not guaranteed but is depending on the performance of the underlying investments. Importantly, living annuity regulations allow the annuitant to elect an income of between 2.5% and 17.5% per annum. However, research indicates that annuitants should not exceed an annual income rate of 5%, otherwise they risk ruin. 2

Having established the income required in retirement, retiring members next need to determine how to access this income in a tax-efficient manner. As indicated above, a minimum income rate of 2.5% per annum must be taken from the living annuity, taxable at the individual’s marginal tax rate. Any income required in excess of this 2.5% can then be drawn from the TFSA. This income is not taxable and therefore minimises the retiring member’s marginal tax rate, as long as capital remains in the TFSA.

Drawing additional income from a TFSA means more money in your pocket for the same level of gross income drawn from the living annuity and TFSA combined.

This is best illustrated by a simplified example. Assume an investor has accumulated R1.8 million (as suggested by Jaco’s article)1 in his TFSA over the preceding 20 years and R7.5 million in his pension fund, which he then converts entirely into a living annuity. He requires an annual income of R350 000 and his only source of income is his TFSA and living annuity.

Below are two scenarios based on the 2020 income tax tables:

Scenario 1:

In year 1 he takes the full R350 000 from his living annuity (a drawdown rate in year 1 of 4.67%). He will pay income tax of R77 539.50 and receive an after-tax income of R272 460.50.

Scenario 2:

In year 1 he takes the minimum 2.5% from his living annuity (R187 500) and the remainder from his TFSA (R162 500). He will only pay income tax of R33 750 and receive an after-tax income of R316 250, i.e. a tax saving of almost R44 000 in year one and which, depending on the changing tax tables, is likely to escalate each year for so long as there is value in the TFSA.

 

Maximise the compounding growth of your retirement capital

Not only does this strategy reduce your marginal tax rate but it also ensures that your living annuity capital continues to compound faster, as your capital is eroded more slowly than it would be were you drawing more than the minimum.

Importantly, as with TFSAs, no income or dividend withholding tax is levied in the living annuity and capital gains tax is not applicable in terms of current legislation – only income paid by the living annuity attracts tax. As is the case for TFSAs, retirement capital invested in living annuities therefore benefits from increased compounding returns.

Minimise any estate duty liability

Estate duty is an important consideration for investors. On death, it would be preferable from an estate duty perspective to have depleted your TFSA (and other discretionary savings), while maximising the capital growth of your living annuity. This is because you may nominate a beneficiary or beneficiaries to receive the benefit on death, which in turn confers tax benefits on them. Beneficiaries may choose to receive the benefit as an annuity, a lump sum (subject to tax) or a combination of the two. Both lump sum and annuity benefits are free from estate duty. Bear in mind that disallowed contributions (retirement fund contributions in excess of a maximum allowable deduction) may be subject to estate duty where such contributions were made after 1 March 2015.

We encourage financial advisors and investors to carefully consider all the financial, retirement and estate planning benefits that TFSAs provide, including when used in combination with living annuities. By investing in a TFSA with Ninety One Investment Platform, investors benefit from a competitive fee structure, transparent pricing and a wide range of funds from Ninety One.

Ninety One Investment Platform TFSA fast facts

These benefits are increasingly being recognised, as illustrated by the following summary data of the Ninety One Investment Platform TFSA as at 31 December 2019 (31 December 2018 details in brackets):

  • Total number of Ninety One Investment Platform TFSA accounts = 17 427 (16 284)
  • Total value of Ninety One Investment Platform TFSA accounts = R1.082 billion (R730 million)
  • Average value per account = R59 627 (R44 833)
  • More than 90% of Ninety One Investment Platform TFSA clients are advised by financial advisors
  • Approximately 94% of all Ninety One Investment Platform TFSA assets are invested in offshore, equity or multi-asset (balanced or flexible) funds, suggesting that these investors are prudently investing for long-term growth
  • Some 40% of Ninety One Investment Platform TFSA assets are invested in our unit trust funds
  • The value of investments in the Global Franchise Feeder Fund exceeds R182 million, making it the most supported fund by some margin

 

1 Changes to the tax treatment of provident funds, introduced as part of broader retirement reforms in 2015 by National Treasury, have been postponed. The proposal is that on retirement, members of provident funds will only be permitted to take up to a third of their retirement benefit, with the balance used to purchase an annuity, i.e. provident funds will be treated the same as pension and retirement annuity funds. The proposed changes will only apply to contributions made to a provident fund after the implementation date.
2 A sensible income strategy is critical for living annuity investors.

Authored by

Paul Hutchinson

Sales Manager

Important information

This communication was originally published by Investec Asset Management (Pty) Ltd, the predecessor of Ninety One SA (Pty) Ltd. The information is accurate as at the original date of publication, but any views expressed may no longer be current. The communication has been republished in our new branding but has not otherwise been updated.

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