TFSAs – helping to maximise your retirement income and minimise your estate duty liability
After 20 years, TFSA investors realise an additional 20% return due to these tax benefits.
Tax-free savings accounts (TFSAs) are a great initiative from government to encourage savings in South Africa. Jaco van Tonder,1 Advisor Services Director at Investec Asset Management, has previously 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. Jaco’s article shows that after 20 years, TFSA investors realise an additional 20% return due to these tax benefits. But little continues to be 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 needs to decide what portion of their retirement benefits they would like 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, retirement funds and linked investment service providers under which the income is not guaranteed but is dependent 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.3
1 TFSAs – how to maximise the value of the tax benefit? Taking Stock Spring 2017.
2 Changes to the tax treatment of provident funds, introduced as part of broader retirement reforms in 2015 by National Treasury, have been postponed. The proposal is that on retirement, members of provident funds will only be permitted to take up to a third of their retirement benefit, with the balance used to purchase an annuity, i.e. provident funds will be treated the same as pension and retirement annuity funds. The proposed changes will only apply to contributions made to a provident fund after the implementation date.
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 the 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)1 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.
Below are two scenarios based on the 2020 income tax tables:
- In 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 R77 539.50 and receive an after-tax income of R272 460.50.
- In 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, i.e. a tax saving of almost R44 000 in year one and which, depending on the changing tax tables, is likely to escalate each year for so long as there is value in the TFSA.
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 is the case for TFSAs, retirement capital invested in living annuities therefore 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 (retirement fund 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 and investors 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.
Investec IMS TFSA fast facts
These benefits are increasingly being recognised, as illustrated by the following summary data of the Investec IMS TFSA as at 31 December 2020 (31 December 2019 details in brackets):
Important information
All information provided is product related and is 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 without appropriate professional advice after a thorough examination of a particular situation. This is not a recommendation to buy, sell or hold any particular security. Collective investment scheme funds are generally medium to long term investments and the manager, Investec Fund Managers SA (RF) (Pty) Ltd, gives no guarantee with respect to the capital or the return of the fund. Past performance is not necessarily a guide to future performance. The value of participatory interests (units) may go down as well as up. Funds are traded at ruling prices and can engage in borrowing and scrip lending. The fund may borrow up to 10% of its market value to bridge insufficient liquidity. A schedule of charges, fees and advisor fees is available on request from the manager which is registered under the Collective Investment Schemes Control Act. Additional advisor fees may be paid and if so, are subject to the relevant FAIS disclosure requirements. Performance shown is that of the fund and individual investor performance may differ as a result of initial fees, actual investment date, date of any subsequent reinvestment and any dividend withholding tax. There are different fee classes of units on the fund and the information presented is for the most expensive class. Fluctuations or movements in exchange rates may cause the value of underlying international investments to go up or down. Where the fund invests in the units of foreign collective investment schemes, these may levy additional charges which are included in the relevant Total Expense Ratio (TER). A higher TER does not necessarily imply a poor return, nor does a low TER imply a good return. The ratio does not include transaction costs. The current TER cannot be regarded as an indication of the future TERs. Additional information on the funds may be obtained, free of charge, at www.investecassetmanagement.com. The Manager, PO Box 1655, Cape Town, 8000, Tel: 0860 500 100. The scheme trustee is FirstRand Bank Limited, PO Box 7713, Johannesburg, 2000, Tel: (011) 282 1808. Investec Asset Management (Pty) Ltd (“Investec”) is an authorised financial services provider and a member of the Association for Savings and Investment SA (ASISA). A feeder fund is a fund that, apart from assets in liquid form, consists solely of units in a single fund of a collective investment scheme which levies its own charges which could then result in a higher fee structure for the feeder fund. The fund is a sub-fund in the Investec Global Strategy Fund, 49 Avenue J.F. Kennedy, L-1855 Luxembourg, Grand Duchy of Luxembourg, and is approved under the Collective Investment Schemes Control Act. This document is the copyright of Investec and its contents may not be re-used without Investec’s prior permission. Investec Investment Management Services (Pty) Ltd and Investec Asset Management (Pty) Ltd are authorised financial services providers. Issued, January 2020.