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 at Ninety One, has shared his insights on how to maximise the value of the TFSA tax benefits.1 The tax advantages 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.

  • 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.
  • From 1 March 2021, members of provident and provident preservation funds are also limited to having up to a third of their retirement benefits paid out in cash, with two notable exceptions:
    1. Members "vested benefits" are protected, i.e. the provident or provident preservation fund value on 1 March 2021, plus future growth on this amount may still be taken in full as a cash lump sum at retirement (subject to tax in terms of the retirement tax table). Only contributions made after 1 March 2021, plus future growth on those contributions will be subject to the annuitisation requirements.
    2. Members of provident or provident preservation funds who were 55 or older on 1 March 2021 will not be forced to annuitise a portion of their provident/provident preservation fund benefit, provided they remain members of the same fund until they retire.

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.

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 below, 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.

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 dependent 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.

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 simple scenarios based on the 2022 income tax tables (and ignoring the tax rebates):

  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 R74 314 and receive an after-tax income of R275 686.
  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 R29 250 and receive an after-tax income of R320 750, i.e. a tax saving of almost R45 064 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 (Ninety One IP), investors benefit from a competitive fee structure, transparent pricing and a wide range of funds from Ninety One.

Ninety One TFSA fast facts

The benefits of a TFSA are increasingly being recognised, as illustrated by the following summary data of Ninety One IP’s TFSA accounts as at 31 December 2021 (31 December 2020 details in brackets):

Ninety One TFSA fast facts

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1 Making the most of your TFSA

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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