Quick question…
Does any of the following apply to you?
- Self-employed?
- Paying a ton in taxes every month?
- Starting to worry about money as retirement slowly but surely creeps up on you?
If you answered yes then the next question you need to ask yourself is…are you leveraging your retirement annuity to the maximum?
What do I mean by ‘leveraging’?
Let’s consider someone who’s self-employed.
Tom earns R10, 000 a month as a commission based salesman.
Tom is allowed a tax deduction of the greater of:
- 15% of his non retirement funding income* (A retirement fund lump sum benefit does not form part of income therefore it cannot be included in this calculation)
- R3, 500 less his allowable pension fund contributions, or
- R1, 750
Tom’s calculation works as follows:
- R120, 000 per annum income x 15% = R18, 000 per annum towards his RA or R1, 500 per month,
- R3, 500 per annum or R292 per month,
- R1, 750 per annum or R145 per month
Since R1, 500 per month is the largest amount applicable to Tom in this calculation, he can thus contribute R1, 500 per month and enjoy the tax deduction.
So what tax savings are we talking about here?
Well let’s take a look at the 2010/11 tax year.
Without the RA deduction Tom would pay R11, 340 in tax.
With the full contribution towards a RA of R1, 500 per month, Tom would only pay R8, 100 in taxes – That’s R3, 240 less!
This means that Tom’s RA only cost R14, 760 (R18, 000 – R3, 240 = R14, 760)!
Let’s do the same calculation with Tom’s boss who also only earns commission…
John earns R600, 000 per annum placing him in the uppermost marginal tax bracket of 40%.
John’s calculation works as follows:
- R600, 000 per annum income x 15% = R90, 000 per annum towards his RA or R7, 500 per month,
- R3, 500 per annum or R292 per month,
- R1, 750 per annum or R145 per month
John also qualifies for the first part of the sum – R7, 500 per month.
For the 2010/11 tax year John would pay R169, 760 in taxes if he didn’t have the RA.
With the full contribution of R7, 500 per month towards his RA, John would end up paying R134, 510 in taxes – R35, 250 less!
This means that John’s RA only cost him R54, 750 (R90, 000 – R35, 250 = R54, 750).
Now imagine for one moment being able to invest a full R90, 000 – and earn a return based on R90, 000 – when in reality it’s only costing you a measly R54, 750.
Now that’s what I call a leveraged investment!
More importantly, can you see that for the individual who’s paying the maximum in personal taxes – and who doesn’t belong to a pension or provident fund – an RA makes perfect sense?
But what if you belong to a pension fund with zero non retirement funding income?
Admittedly the tax benefit of owning an RA is much smaller here.
The individual who belongs to a pension fund is allowed a deduction of up to 7, 5% of his or her pension funding income. Since all of his or her salary is considered to be retirement funding income, he or she does not qualify for the 15% rule.
Let’s work with John once more, only this time he belongs to the company pension fund and his contribution is 7, 5% of the R600, 000 per annum he earns – or R3, 750 per month.
The sum works as follows:
- 15% of his non retirement funding income (Which is Nil)
- R3, 500 less his allowable pension fund contributions (R3, 500 – R3, 750 = Nil)
- R1, 750
John may contribute R1, 750 per annum (or R145 per month) towards an RA.
Without the RA John would pay R151, 670 in taxes.
With the RA John would pay R150, 970 in taxes – a saving of R700 in taxes.
Still, his R1, 750 per annum investment only ended up costing him R1, 050!
What of the individual who belongs to a provident fund with zero non retirement funding income?
The individual who belongs to a provident fund is not allowed a tax deduction based on his or her membership.
His or her salary is still considered to be retirement funding income since contribution is based on their income.
This means that the first rule (The 15% of non-retirement funding income calculation) does not apply!
Let’s once again take John with his R600, 000 per annum income. John does not contribute to the provident fund personally as the company he works for makes the full contribution.
Remember that even though John does not personally contribute, the company contributions are based on his income which makes his income retirement funding!
The sum works as follows:
- 15% of his non retirement funding income (Which is Nil)
- R3, 500 less his allowable pension fund contributions (R3, 500 – R0 = R3, 500)
- R1, 750
John may contribute R3, 500 per annum since it’s greater than the R1, 750.
Without the RA John would pay R169, 670 in taxes.
With the RA John would pay R168, 270 in taxes – a saving of R1, 400 in taxes.
His R3, 500 per annum investment ended up costing him R2, 100 which is still money for nothing!
And there you have it…
In the next financial planning article we’ll run through the remaining advantages as well as disadvantages (Just in case you thought I was going to paint a rosy picture of RA’s as the be all and end all!) of investing in a retirement annuity.
Till then
*Certain individuals may take exception to the fact that I use the term ‘non retirement funding income’. Strictly speaking, there are certain expenses which must first be deducted from such ‘non retirement funding income’ before proceeding (An example of this would be car allowance deductions). I would recommend consulting with a financial planner when doing your personal calculation.
Related posts:
- When It Comes To Retirement Annuities…The Tax Man Ain’t Stupid!
- How Much Is Left Of Your Pension Once The Taxman Takes His Cut At Retirement?
- Investment | How To Not Outlive Your Living Annuity
- How Do They Calculate Capital Gains Tax?
- How Much Life Insurance Do You Need To Cover Capital Gains Tax?
Article by Lawrence
Someone, who as he gets older, finds he has more questions than answers
Lawrence has written 150 awesome articles for us at Insurance Fundi
