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TFSAs - maximising retirement income, minimising estate duty

14 February 2019
Author: Paul HutchinsonSales Manager

By Paul Hutchinson, Sales Manager, Investec Investment Management Services

Tax-free savings accounts (TFSAs) are a great initiative from government to encourage savings in South Africa. In a recent article, Jaco van Tonder1, Advisor Services Director at Investec Asset Management, discussed how to maximise the value of the TFSA tax benefits, which are well documented. You pay no tax on dividends and interest received and no tax on capital growth. As a result you benefit from increased compounding of returns. In his article Jaco projects a TFSA’s fund values based on a number of assumptions, and illustrates that after 20 years, TFSA investors realise an additional 20% return as a result of these tax benefits. But little has been said about the potential retirement and estate planning tax benefits.

The first choices

Anyone retiring from a provident, pension, provident preservation, pension preservation or retirement annuity fund can elect to have all or a portion of their retirement benefits paid out as a cash lump sum.

  • Provident and provident preservation fund members can currently2 elect to have their entire retirement benefits paid out as a cash lump sum.
  • Pension, pension preservation and retirement annuity fund members can elect to have up to a third of their retirement benefits paid out as a cash lump sum.

Where there is a balance remaining, this must be used to purchase an annuity, either a guaranteed or living annuity, which pays a monthly income that is taxable at the annuitant’s marginal tax rate.

How can a TFSA help reduce this potential income tax liability?

A TFSA can help a retiring member who has chosen a living annuity reduce their marginal tax rate, hence maximise their after-tax income.

A living annuity is a compulsory purchase annuity offered by insurers and retirement funds, under which the income is not guaranteed but is depending on the performance of the underlying investments. Importantly, living annuity regulations allow the annuitant to elect an income of between 2.5% and 17.5% per annum. However, research indicates that annuitants should not exceed an annual income rate of 5%, otherwise they risk ruin.

Having established the income required in retirement, retiring members next need to determine how to access this income in a tax-efficient manner. As indicated above, a minimum income rate of 2.5% per annum must be taken from the living annuity, taxable at the individual’s marginal tax rate. Any income required in excess of this 2.5% can then be drawn from the TFSA. This income is not taxable and therefore minimises the retiring member’s marginal tax rate as long as capital remains in his TFSA.

Drawing additional income from a TFSA means more money in your pocket for the same level of gross income drawn from the living annuity and TFSA combined.

This is best illustrated by a simplified example.

Assume an investor has accumulated R1.8 million (as suggested by Jaco’s article) in his TFSA over the preceding 20 years and R7.5 million in his pension fund, which he then converts entirely into a living annuity. He requires an annual income of R350 000 and his only source of income is his TFSA and living annuity. Based on the 2018 income tax tables:

Scenario 1:

Year 1 he takes the full R350 000 from his living annuity (a drawdown rate in year 1 of 4.67%). He will pay income tax of R78 482.60 and receive an after-tax income of R271 517.40.

Scenario 2:

Year 1 he takes the minimum 2.5% from his living annuity (R187 500) and the remainder from his TFSA (R162 500). He will only pay income tax of R33 750 and receive an after-tax income of R316 250.


Maximise the compounding growth of your retirement capital

Not only does this strategy reduce your marginal tax rate but it also ensures that your living annuity capital continues to compound faster, as your capital is eroded more slowly than it would be were you drawing more than the minimum. Importantly, as with TFSAs, no income or dividend withholding tax is levied in the living annuity and capital gains tax is not applicable in terms of current legislation – only income paid by the living annuity attracts tax. As a result, and as is the case for TFSAs, retirement capital invested in living annuities benefits from increased compounding returns.

Minimise any estate duty liability

Estate duty is an important consideration for investors. On death it would be preferable from an estate duty perspective to have depleted your TFSA (and other discretionary savings), while maximising the capital growth of your living annuity. This is because you may nominate a beneficiary or beneficiaries to receive the benefit on death, which in turn confers tax benefits on them. Beneficiaries may choose to receive the benefit as an annuity, a lump sum (subject to tax) or a combination of the two. Both lump sum and annuity benefits are free from estate duty. Bear in mind that disallowed contributions (contributions in excess of a maximum allowable deduction) may be subject to estate duty where such contributions were made after 1 March 2015.

We encourage financial advisors to carefully consider all the financial, retirement and estate planning benefits that TFSAs provide, including when used in combination with living annuities. By investing in a TFSA with Investec IMS, investors benefit from a competitive fee structure, transparent pricing and a wide range of funds from Investec Asset Management.

Paul Hutchinson
Paul Hutchinson Sales Manager

Important information

All information and opinions provided are of a general nature and are not intended to address the circumstances of any particular individual or entity. We are not acting and do not purport to act in any way as an advisor or in a fiduciary capacity. No one should act upon such information or opinion without appropriate professional advice after a thorough examination of a particular situation. Fluctuations or movements in exchange rates may cause the value of underlying international investments to go up or down. We endeavour to provide accurate and timely information but we make no representation or warranty, express or implied, with respect to the correctness, accuracy or completeness of the information and opinions. We do not undertake to update, modify or amend the information on a frequent basis or to advise any person if such information subsequently becomes inaccurate. Any representation or opinion is provided for information purposes only. This is the copyright of Investec and its contents may not be re-used without Investec’s prior permission. Investec Asset Management and Investec Investment Management Services are authorised financial services providers. Issued by Investec Asset Management, December 2017.

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