Both retirement annuities (RA) and tax-free savings accounts (TFSA) earn tax-free investment returns. However, an RA defers income tax to the post retirement phase whereas with a TFSA, income tax is paid before every contribution is made.
When saving for retirement, should a TFSA be used instead of an RA?
Let’s use an example to show what the numbers show us about which product gives a higher after-tax income in retirement.
A client with a pre-retirement marginal income tax rate of 45% invests R2 750 per month into a TFSA. This client’s equivalent pre-tax contribution to an RA is R5 000 per month1. The investment term for both products is 15 years2.
If we use an investment return of 6% per annum (after costs), the fund values of the TFSA and the RA are R792 900 and R1 441 500, respectively.
Now, although the fund value of the RA is higher, the client will still need to pay tax on the income drawn from the RA in retirement whereas income drawn on the TFSA is tax-free.
Therefore the client’s income tax rate post-retirement, and whether he utilizes his tax-free lump sum allowance on retirement, will also impact on the numbers. We have used three scenarios to assess this.
- The RA contribution of R5 000 p.m. is calculated as 2750/(1-0.45).
- Over the term of the investment the client contributes a fxed monthly amount of R5 000 and R2 750, respectively.
Note that this article only considers the numerical differences between an RA and a TFSA.
There are however other factors to also consider when deciding between which savings product to use – among others:
Estate Duty
RAs are exempt from estate duty. On death of the RA member any proceeds paid to dependents or beneficiaries fall outside of the member’s estate. This does not apply to TFSA’s.
Liquidity
A TFSA offers access to savings at any time. Savings held in an RA can only be accessed from age 55 onwards.
Asset allocation
An RA needs to comply with Regulation 28 of the Pension Funds Act, which limits the range of assets that can be held in a members fund. Although a TFSA has fewer asset class restrictions, it does not allow investment funds with performance fees.
Assumptions
The client retires at age 65 and draws an income of 5% p.a. In scenarios B and C we assume that the lump sum is invested in a discretionary LISP and that the interest exemption of R34 500 (which is assumed to be frozen at this level) is used to offset any interest income earned on this investment.
These numbers only show the financial benefit of an RA over a TFSA in the 1st year of retirement. In practice the gap will continue to widen in future years. The financial benefit of an RA over a TFSA is also independent of the contribution amount and the tax rates used.
In conclusion
An RA gives the same or better value at retirement compared to a TFSA due to the numerous post-retirement tax-benefits available to individuals who save through an RA. These include:
- Lump-sum tax-free allowance of up to R500 000 on retirement
- Primary plus secondary income tax rebate of R21 114 (2017 – 2018 tax-year)
- In general, a lower marginal tax-rate post-retirement compared to pre-retirement
- Did you know you can save on personal income tax when contributing to a retirement annuity
- You may deduct up to 27,5% of your gross remuneration or taxable income (whichever is the higher) in respect of your total contributions to a pension, provident or retirement annuity fund, subject to an annual limit of R350 000. Simply put if your tax rate is 35% ,for every R1.00 you contribute , you save 35cents in income tax. You can get this relief when submitting your tax certificate with your filing or immediately see the cashflow benefit via your company payroll on your pay slip.
- IF YOUR TAX RATE IS 35% FOR EVERY R1.00 you contribute you save 35 cents in tax-