What would the average South African prefer doing – Saving for a rainy day or splashing out on a new smartphone?
Buying the smartphone, of course. What did you think?
So can you imagine the dilemma facing the government when it came to encouraging people to save?
“How are we going to encourage the man in the street to start saving so that they don’t become a burden on us at retirement?”
“Why don’t we give them a tax break if they save?”
“Great idea but how do we get that right without it costing an arm and a leg?”
“Let me explain. All we do is structure it much the same as a retirement annuity. Let’s not give them the annual tax deduction available with a retirement annuity. That way it won’t end up costing the fiscus much. Then we sell them on the benefit of not paying tax on the interest, the capital gains, or the dividends. Of course, the fat cats will try to abuse this, so what we do to stop them is cap the annual investment at R30,000 and limit it to R500,000 over their lifetime. It will be years before we lose money on the taxable interest, capital gains tax, and taxable dividends.”
That, in essence, is what a tax-free savings account is all about.
The first article we wrote on the subject was titled should you invest in tax-free savings accounts? The follow-up article was retirement annuity or tax-free savings account? Today we look at what happens when you cash in.
Yet tax-free savings accounts do have one big advantage over retirement annuities
It pays out tax-free, and the reason it does this is that you didn’t receive a tax deduction on what you invested in the first place. You’ve been investing after tax money so how can they now tax you on the payout?
A retirement annuity works slightly different. You get the immediate tax incentive of being able to deduct this year’s contribution from this year’s income.
But it’s at retirement that the taxman gets even with a retirement annuity.
- At retirement, you are only allowed one-third in cash (Unless your retirement annuity is worth less than R75,000 in which case you take the full amount). Of that one-third, the first R500, 000 is paid to you tax-free (That’s assuming you haven’t already used the R500,000 once-off allowance when retiring from a pension or provident fund). The rest of the one-third gets taxed on a sliding scale.
- The remaining two-thirds is then used to buy you a taxable income. You take the two-thirds and buy what’s known as a compulsory purchase annuity. This annuity pays you an income. When I say taxable income, I mean that you receive an IRP 5 every year and you submit a tax return reflecting this income.
A tax-free savings account has no immediate tax incentive. But the day you cash in your tax-free savings account is the day you get your full lump sum paid out free of tax.
But the retirement annuity does have one last trick up its sleeve
What if you kick the bucket before reaching retirement?
The thing about a retirement annuity is, that it doesn’t fall into your estate when you pass away. It gets treated in the same way as if you had retired.
The first R500,000 is paid out tax-free and the balance gets taxed on a sliding scale of between 18% and 36%. The only difference between retirement and death is the ‘one-third two-thirds’ rule. At death, the full lump sum gets paid out to your heirs.
With a tax-free savings account, the lump sum falls into your estate. Now, this shouldn’t be a problem for most. For one, most of us would leave it to our spouse anyway, and two, because the first R3,5 million of your estate pays out free of estate duty.
If you leave everything to your spouse then none of it is taxable. However, it will be subject to executor’s fees of 3,5% excluding VAT.
But if the portion of your estate is left to anyone else besides your spouse exceeds R3,5 million, then the portion exceeding R3,5 million is taxed at 20%.
So there you have it
In favour of the Retirement Annuity:
The higher your marginal rate of tax, the more a retirement annuity makes sense. That’s because a larger portion of your contribution to your retirement annuity is tax deductible – 41% of a R200 a month investment is more than 18% of the same amount.
Of course, a retirement annuity really comes into its own if you don’t belong to a pension or provident fund.
In other words, it’s best if you qualify for the full 15% deduction.
In favour of the Tax-Free Savings Account:
A tax-free savings account remains a great way to save for your child’s education. You can open up an account in their name and start saving today. But remember not to dip into your savings whenever you’re in a tight spot.
You can’t have your bread buttered both ways, and if you dip into your tax-free savings account, it gets deducted from your R500,000 lifetime allowance.
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