Many business owners have had to face the reality of either postponing their retirement or seeing their retirement plans wiped out due to the economic realities at the time they want to sell their business.
The question is whether or not one should be saving for retirement in a retirement annuity.
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The Upside and Downside
A big plus for business owners is that a retirement annuity is completely protected from creditors. It is the one asset that your creditors cannot touch, not even SARS. This means even if your business fails, your creditors cannot touch your retirement provision.
Your contributions to a retirement annuity are tax-free up to 15% of your income (this is likely to be raised to 27% in 2016), and no tax is paid on dividends, interest or capital growth.
The downside is that investment restrictions apply in order to ensure the savings are used for the intended retirement purpose. You can only access your retirement annuity at retirement age (55 is the earliest you can select) and then you have to invest two-thirds into an annuity to provide you with an income in retirement and this income is taxable.
The counter argument is to rather invest in a discretionary fund such as a unit trust or share portfolio. One would have full flexibility and although you would not receive the tax benefit on the contributions, nor on the growth of the fund, in retirement you do not pay income tax on your withdrawals (although capital gains tax would apply). This investment would not be protected from creditors.
Weighing up the pros and cons, the tax benefits of a retirement annuity are significant and cannot be ignored, especially at the current rate of dividend tax and capital gains tax. In addition, the protection from creditors offered by a retirement annuity is especially valuable to business owners.
Research by Rowan Burger, executive: Large Corporate Segment at Momentum shows that over a 35 year period the tax benefit of contributing to a retirement annuity versus a discretionary investment for a high income earner increases your income in retirement by a massive 67% – this is even taking the income tax paid in retirement into account.
Lump Sum on Retirement
Burger’s assumptions were based on an individual with a starting salary of R500 000 per annum increasing at inflation each year, contributing 15% of their pre-tax salary per year with a marginal tax rate of 40%. Burger assumed that the individual started saving at the age of 30 and retired at the age of 65.
He assumed a growth rate of 10% per annum on both investments adjusting the unit trust returns for capital gains, dividend tax and tax on interest but took into account that a retirement annuity would cost 0,1% per annum more than a unit trust given the governance costs. (See table one)
Due to the tax deductibility of the contributions and the fact that no tax is paid on dividends, interest income or capital gains, the net effect at retirement is R38,7 million in a retirement annuity versus R15 million for a discretionary investment. Before you commit to buying a Ferrari with that impressive number, remember that this is a little more than R5 million in today’s money.
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Income in Retirement
As tax is paid on the income drawn from an annuity in retirement, Burger also calculated the net (after tax) income from both a living annuity and a unit trust. The unit trust investment now attracts far less tax. Due to the lower taxes paid by individuals over the age of 65, the marginal tax rate has fallen to 35%.
Burger assumed that the individual would draw 5% of the capital annually and the funds would grow at 10% per annum.
Because a living annuity in retirement also does not attract dividend, interest or capital gains tax, the net growth rate will be higher than a discretionary fund. So although in the first year the difference between the two incomes is 67%, by the time you reach 75 that difference is 101%. (See table two)
So taking all the various tax factors into account and assuming similar investment portfolios, a retirement annuity makes financial sense as long as you ensure that it is a low cost product fairly comparable to a unit trust investment.