While the impact of the new budget will continue to be analysed for some time, a key implication for financial advisers and their clients is that the retirement annuity is now even more effective as a retirement planning and savings vehicle.
Two major changes announced by the government – the introduction of a 15% withholding tax on dividends and an increase in Capital Gains Tax (CGT) from 25% to 33.3% (along with the current other benefits) have combined to make the RA a more powerful tool than in the past – as the RA’s remain exempt from these taxes.
Forget the negative publicity of a few years back, which made retirement annuities seem unattractive due to inflexibility, a lack of transparency, high administration costs and heavy penalties. Modern RAs have largely addressed those negatives, offering far greater cost effectiveness and flexibility of solutions. Equally importantly, the tax shelter provided by RAs are now a highly effective way of minimising the impact of withholding tax, the increase in CGT as well as tax on interest.
In short, the modern retirement annuity – and the linked RA specifically – is going to be a critical weapon in the financial adviser’s arsenal in assisting investors to meet their retirement savings goal.
Let’s look firstly at withholding tax. Prior to the budget, many experts believed that the 10% secondary tax on companies (STC) would be offset by a new withholding tax rate of 10% – leaving investors in a fairly neutral situation. But, as we know, the rate was set at 15%.
Secondly, the unexpected surprise in the budget was to increase Capital Gains Tax, where the inclusion rate has moved up from 25% of an individual’s capital gains to 33.3% – effectively moving the tax on capital gains from 10% to 13.33%.
This has two implications for taxpayers. Anyone who saves via mechanisms such as unit trusts or share investments over a period of 20-25 years is now going to be taxed on their dividends at a rate of 15%. The result, obviously, is a far lower return over the long term.
The other implication is that, should the taxpayer and financial adviser decide to switch some investments into lower or higher risk assets so as to take advantage of market conditions, these may result in a capital gain – and CGT therefore being applied at the higher inclusion rate of 33.3%. So it’s a double whammy, and the compound negative effect is, over a period of time, substantial.
Add the existing exception of tax on interest; the retirement annuity becomes a very powerful vehicle indeed. The law even allows 15% of your taxable income to be placed into retirement products like your pension fund and RA, which has the effect of also lowering the individual’s tax base. In fact, from 2014, people under the age of 45 will be able to deduct 22.5% and those older than 45 up to 27.5% of taxable income for contributions to retirement products.
Annual deductions will be limited to R250 000 per annum (for over 45’s the limit is R300 000 per annum).
Modern RAs, sometimes called ‘linked RAs’, also allow the flexibility to switch into equity, bond or cash funds, unit trusts or any other suitable investment at anytime without the burden of capital gains tax. If the taxpayer and financial adviser believe there’s an opportunity to take some profits, that’s possible too. This provides greater flexibility to manage one’s investments over the long-term without having to worry about the tax implications of your investment decisions. The modern RA even gives you total flexibility in selecting multiple, suitable asset managers and to change them at any time without penalties.
The beauty of the RA is that this activity and profit-taking and income generation is free of any taxes. So, if you compare investing in plain unit trusts, versus the same investment via a retirement annuity, the compounding effect is enormous over a 20 year period and means you’re actually earning 15% more on dividends, 40% more on your interest and property income and 13.33% more on your capital gains. Therefore, over a prolonged period, an RA creates far greater retirement wealth.
Consider the following rough calculation when investing someone’s bonus of R100 000, which is placed either in unit trusts or an RA. If you compare the after tax growth over a period of 20 years, the unit trusts will deliver an investment of approximately R560 000, versus about R1,37 million in an RA!
Yes, it sounds remarkable. But remember that in an RA there are no tax deductions, either at commencement of investment (on the original R100 000) or during the life of the investment – no tax on interest, dividends or capital gains. So, providing all these amounts are re-invested in the RA, the compounding effects over 20 years brings you to the figure of R1,37 million.
By contrast, the non-RA investment of the bonus immediately loses R40 000 to tax, meaning the original after tax investment figure is only R60 000. Then, at each stage of the journey, dividends, CGT and interest are also taxed. The net result is a significantly reduced amount of only R560, 000 – less than 50%! The impact over 20 years of someone contributing R10 000 per month is even more significant.
By transferring the R1,37 million into a Linked Living Annuity (LLA’s) one can continue to protect your client’s investments from tax while being able to provide your client with a far higher income in his/her retirement – R48 101 per annum vs. R25 687 per annum after tax and CGT on post retirement income. And the fact that RAs and LLA’s are free from estate duty as well makes the argument for RAs even more attractive.
Let’s not forget one final benefit for financial advisers: because RAs are an instrument which clients are obliged to leave untouched until age 55, there’s a fantastic opportunity for a ‘sticky’ and long-term relationship. And, even in post-retirement, there’s the opportunity to advise on the living annuity.
So, in the new budget environment, the RA can truly be a win-win for clients and advisers!
NB: Assumptions have been based on an average return of the balanced fund over the past 10 yrs, which is at 14% per annum, and an average interest and dividend income earned on these investments over this period.