In the process of wealth creation, the impact of taxation remains the single biggest detractor. As such, where an investor has the opportunity to invest in a tax-efficient or incentivized manner, it is always advisable to leverage these benefits to one’s advantage. As most South African investors know, the most common tax benefit when it comes to investing is the tax-deductibility of contributions made towards approved retirement funds.
Approved retirement funds include occupation funds offered as a result of one’s employment, being provident and pension funds, and retirement annuity funds which are taken out in one’s individual capacity. Simply speaking, contributions made to any of these funds are tax-deductible up to a maximum of 27.5% of taxable earnings, up to a maximum of R350 000 per year.
While many South African investors make use of retirement funds to build wealth for their retirement years, many do not take the opportunity to structure their contributions in a pre-tax manner – which can inadvertently affect the growth of one’s investments. Remember, compulsory contributions towards a company-sponsored pension or provident fund are made pre-tax, contributions towards a retirement annuity are generally made after-tax. In other words, private RA investors generally make their RA contributions from their net, after-tax earnings and, while these contributions are still tax-deductible, it is important to bear in mind that the investor will only really reap the benefit of the tax deductions in the following tax year, in other words when the investor receives their tax refund from SARS. In such circumstances, the investor will generally use the refund to make an ad hoc lump-sum contribution towards her RA so as to gain further tax deductions in the current tax year.
Let’s take the example of Noxi, who currently invests an amount of R5 000 per month towards her retirement annuity on an after-tax basis.
|Table 1: Post-tax saving scenario|
|Gross income (per month)||R40 000|
|Less: Tax on income||-R8 053|
|Net income||R31 947|
|Less: Monthly RA contribution||-R5 000|
|Net cash||R26 947|
In the above example, it is clear that during the course of the tax year, Noxi would contribute a total of R60 000 (being R5 000 x 12) towards her retirement annuity after tax. Being tax-deductible, Noxie can expect to receive a tax refund in the following tax year of approximately R18 600. If Noxie chooses to invest her refund into her RA as a lump sum, her total contribution would be in the amount of R78 600. The drawback to this approach is that Noxi’s total contribution of R78 600 is being made across two different tax years. This is because her monthly contributions totalling R60 000 are made in the initial tax year, while the remaining R18 600 is invested in the subsequent tax year once she has received her refund from SARS. The delay in investing her refund from SARS directly impacts the potential compounding that her investment would enjoy should she invest the full R78 600 in the initial tax year.
In order for Noxi to more fully benefit from the power of compounding, it would make better sense for her to invest towards her RA on a pre-tax basis. In doing so, Noxi will benefit from tax deductions on a monthly basis which, in turn, will allow her to increase the net annual contribution towards her RA, assuming that she is happy to draw the same net cash amount at the end of each month (as per the post-tax saving scenario in the table above).
Noxi can now increase her monthly contributions to her RA in order to receive a pre-tax deduction while maintaining the same net cash position at the end of each month. As she is increasing her RA contribution pre-tax, Noxi’s taxable income will be lowered as per the table below:
|Table 2: Pre-tax saving scenario|
|Gross income||R40 000|
|Pre-tax deduction of RA||-R7 250|
|Adjusted gross taxable income||R32 750|
As is evident from the above, by increasing her monthly retirement fund contribution to R7 250 and using a pre-tax deduction, Noxi has lowered her monthly taxable income to R32 750, although she is still earning a gross income of R40 000 and netting an income of R26 945 per month, as per the table below.
|Gross income||R40 000|
|Less: Tax on adjusted taxable income||-R5 805|
|Net income||R34 195|
|Less: Monthly RA contribution||-R7 250|
|Net cash||R26 945|
As is evident from the above table, Noxi is in the same net effective position, although her annual contributions to her retirement annuity have increased to R87 000, while in the post-tax scenario in Table 1 above, Noxi’s total retirement fund contributions were R78 600. This translates into an increase of 10.69% in contributions simply by rearranging how and when the tax deduction is applied. In addition to the above, all contributions made in the pre-tax scenario are made in the initial tax year and are not straddled across two years, meaning that these contributions are exposed to the markets between 12 and 18 months longer than in the post-tax saving scenario.
While the figures used in the above examples may appear nominal, keep in mind that when applied year after, the increased contributions in addition to the additional period of compounding can have a dramatic effect on the longer-term growth of Noxi’s investments. Further, as Noxi moves into a higher tax bracket, the effect of saving on a pre-tax basis will be even greater. The example above serves as a reminder that strategic tax planning is an integral part of the financial planning and wealth creation process.
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