The tax burden on South Africa’s higher income earners has swollen in recent years, with this segment of the population facing a top marginal income tax rate of 45%, capital gains tax of 18%, estate duties up to 25%, donations tax at 25% and dividend withholding tax of 20%.
That’s in addition to the increases in the VAT rate, fuel levies, sin taxes, and other taxes shared by everyone in the country. With most state-owned enterprises bleeding cash and an urgent need to build infrastructure and fund social services, the amount of tax we all pay will increase each year for the foreseeable future.
This environment means that it’s more important than ever for every South African to embrace tax efficiency as a central goal in their financial planning. Over this series of articles, I will outline some of the strategies you can use to reduce your effective tax burden and grow your wealth.
Let’s begin by looking at retirement funding, which remains one of the most popular and effective ways to save on tax while investing for the future. Your contributions to a retirement annuity (RA), pension fund or provident fund are deducted from your taxable income, up to a ceiling of 27.5% of your taxable income and R350,000 a year.
If you are an executive, professional or retiree earning R1 million taxable income a year, you will pay income tax of around R313,000 for the 2019 tax year. Should you take advantage of the maximum tax deduction for retirement fund contributions, you will reduce your tax burden to around R200,000 by investing R275,0000 in an RA or pension/provident fund.
Not only will you reduce the tax burden by approximately R113,000 a year, you will benefit from generating returns on a higher amount of capital. What’s more, you will not face any income tax, capital gains tax or dividend withholding tax on the returns generated within a retirement funding vehicle.
Upon retirement, you can receive a tax-free lump sum payment of R500,000 from your aggregated retirement funds. Larger cash lump withdrawals are taxed on a sliding scale that goes up to 36%, which represents a healthy saving for people who are taxed at the higher marginal rates of 41% or 45%. The income received post-retirement is taxed at the marginal tax rate applicable at that point, but that rate is usually much lower than pre-retirement – this will be discussed more fully in the next article.
Contributions to a retirement fund also insulate some of your savings from estate duties should you die before retirement or before depleting your retirement fund once in retirement. You can leave the proceeds of your retirement funds to your family with no estate duty (up to 25% of the estate) or executor’s fees (set at a maximum of 4.025% of the estate including VAT) to be paid.
As much sense as it makes to make use of retirement funding for tax-efficient investment, you should also be aware of some of the drawbacks:
- Retirement funds can invest only up to 30% of your funds offshore, with an extra 10% allowed for Africa excluding South Africa). This limits your ability to shelter yourself against rand volatility and to take advantage of growth opportunities outside the country.
- Only up to 75% of your retirement funds can be invested in equities, which means you may give up some of the growth opportunities of a higher risk investment strategy.
- You cannot usually access your funds until you retire unless you change employers or formally emigrate—this is a pro in the sense that you are forced to preserve savings for retirement, but a con in that it limits your flexibility.
- Retirement funding products attract product administration fees, though the additional cost over the equivalent discretionary (non-retirement) investment is much lower than it used to be. The new style products are generally cheaper and more transparent and flexible than they were before – entry, exit and switching fees or penalties are also a thing of the past.
All of that said, retirement funding, even for affluent individuals, is a cornerstone of good, tax-efficient financial planning. In my next article, I will delve into the role of living annuities and how these can be used to help you maximise your tax efficiency when your RA, pension fund or provident fund matures, and you retire.