Jan 13, 2020
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.
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.
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.
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):
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.
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.
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):