Tax-free savings account vs retirement plan

Article source: Moneyweb 

What the numbers do (and don’t) tell you

Where does a tax-free savings account fit into my financial plan? This may well be the question many investors will need to answer in the coming months.

The launch of tax-free savings accounts on March 1 this year offers a great opportunity for retail investors to access some additional tax savings. The accounts will allow individuals to invest R30,000 a year up to a lifetime maximum of R500,000 in a variety of asset classes. All proceeds on investments in these accounts – dividends, interest and capital gains – will be completely tax-free.

Tax-free savings accounts are part of government’s drive to reform non-retirement savings and are not explicitly intended as a vehicle to save for retirement. The idea is rather that these accounts will prevent South Africans from accessing their retirement savings in the event of a crisis. It is therefore envisioned to be more of a medium-term savings vehicle.

Yet, nothing prevents investors from using these accounts as a vehicle to save for long-term goals like retirement. In fact, some calculations suggest the real benefit of these accounts is only truly unlocked in the long run.

But how does a tax-free savings account stack up against a retirement fund?

In an article published in the South African Index Investor’s Fourth Quarter Newsletter, Daniel Wessels, a financial advisor at Martin Eksteen Jordaan Wessels in Cape Town, compares the two options.

Wessels considers a contribution of R2,500 a month to both types of investments over 200 months (the time it takes to reach the R500,000 lifetime contribution cap for the tax-free savings account). After 200 months, an annual drawdown of 5% is made.

The withdrawals from the tax-free savings account will be non-taxable but such withdrawals from the retirement fund (annuity) will be fully taxable. On the other hand, contributions towards the retirement fund are tax-deductible, while the contributions to the tax-free savings account are not,” he notes.

Thus the pension fund investor will receive his tax saving upfront. If one assumes a marginal tax rate of 40% and an annual contribution of R30,000, the tax saving would amount to R12,000 for the year or R1,000 a month, Wessels argue.

To “compensate” for this difference, the additional R1,000 is added to the monthly contribution of the retirement fund investor.

The calculations below show the annual after-tax proceeds from a 5% drawdown on both investments after 200 months.

* Source: Daniel Wessels (** A conservative estimate)

Under these assumptions, the tax-free savings vehicle will marginally yield better results than the retirement fund, but at lower marginal tax rates (30% and lower), the retirement fund option will yield a slightly better outcome,” Wessels says.

However, there are also other factors to consider.

Wessels says while retirement assets are exempt from estate duty, tax-free savings accounts will likely be included in one’s estate. Also, retirement fund assets are protected against creditor claims, while this might not be the case with tax-free savings accounts.

Moreover, retirement assets are typically more difficult to access (in the case of retirement annuities, the funds only become available after 55), while tax-free savings accounts will typically have no liquidity constraints, he says.

While the calculations only cover a period of 200 months, it is perhaps also important to consider that there are no limitations to the amounts or time period in which contributions to retirement funds could be made (although the tax benefit would be capped). A capital contribution of R2,500 over 200 months would never be able to compete with an “uncapped” contribution over a working life of 480 months (40 years), provided the funds are not withdrawn at any point (and the contributions and returns are comparable).

Wessels says for the vast majority of South Africans a pension fund or retirement annuity is still the best vehicle to save for retirement in the long run, although the tax-free savings account can be a great way to supplement retirement income.

It is also an excellent vehicle to save for especially longer-term goals, he says.