We answer some reader questions about retirement funding: some want to invest, and others want to cash out. We look at the pros and cons.
Listen to Maya and Mapalo Makhu discussing this topic in the My Money, My Lifestyle podcast.
How much tax do I save by investing in a retirement annuity?
I would like to start investing in a retirement annuity. How much will I save from SARS if I save R5 000 a month into a retirement annuity?
A contribution to a retirement annuity (RA) is done with pre-tax money. This means you can use your contribution as a tax deduction. This reduces your taxable income and therefore the amount of tax you owe to SARS. The amount of tax you save will be determined by your tax rate.
For example, if your taxable income is R300 000 a year and you then contribute R60 000 a year (R5 000 a month) to an RA, your taxable income is reduced to R240 000.
- On a taxable income of R300 000 you pay R48 112 in tax
- On a taxable income of R240 000 you pay R32 511 in tax
You effectively save R15 600 in tax. The higher your income, and therefore tax rate, the greater the tax saving. In this example if your taxable income was R600 000 and you contributed R60 000 to an RA, your tax liability would reduce from R150 986 to R128 054 which is a tax saving of R22 932.
This tax saving is paid as a tax refund and you need to invest that refund into your retirement annuity to really use that tax benefit to boost your retirement.
Keep in mind that there are limits to investing in a retirement annuity or any retirement fund. You can only contribute a maximum of 27.5% of your total income up to a maximum contribution of R350 000.
Apart from the tax deduction, any growth or interest earned in a retirement annuity is not taxable. However, on retirement you must use two-thirds to purchase an annuity income and this income is taxable as it forms part of your income. However, the tax benefit during your higher-income-earning years together with no tax on the growth, more than offsets the tax you pay on the income in retirement.
How much tax will I pay on my pension withdrawal?
I plan on resigning from my employer at the end of the year. I am 51 years old, I currently earn R480 000 a year and my pension is worth R3.2 million. If I withdraw my pension, how much tax will I pay and what can I invest my money in to generate an income?
If you decide to cash in the retirement fund you will pay a massive R1 million in tax. That will reduce your pension to R2.2 million. There is no investment you could make to catch up that massive loss.
When it comes to income in retirement, a general rule of thumb is to calculate a 4% to 5% drawdown rate. This is the amount you could afford to take as income each year whilst ensuring that the capital does not reduce significantly. If you draw too much each year you deplete your capital leaving you with no money in your later years. In this scenario, even if you had the full R3.2 million, you could only expect an annual income of R160 000 which is a third of what you currently earn. After paying R1 million in tax, that potential income reduces to R110 000 a year.
If you want to resign, rather transfer the money to a preservation fund to protect it from tax. Alternatively, you could ask your employer if you have the option to leave the retirement funds with the company fund until you retire.
At the age of 55 you can take retirement and benefit from the retirement tax tables where the first R500 000 is tax exempt (assuming you have not made any withdrawals previously).
Rather than trying to turn your pension withdrawal into income, look for ways to earn money and cover your bills until at least the age of 55. Ideally you should aim to only touch your retirement funds at the age of 65 so that they have time to grow and you do not have so many years of retirement to fund.
Should I use my retirement fund to settle debt?
What would be your advice be about withdrawing a significant amount from a retirement fund to settle a large credit card debt?
It is usually a bad idea to withdraw your pension fund due to the high taxes paid and the loss of compound growth on the pension value.
Settling debt sounds like a good idea, as interest rates on credit-card debt can be as high as 25%, while your pension may only be growing at 10%. However, people underestimate how powerful compound growth can be over the period of one’s career. We also tend to overestimate our willpower or ability to change our spending behaviour.
For example you are 30 years old and you cash in R100 000 of your pension. If over the long term the pension is growing at 10% per annum, it would double in value every seven years. So, after seven years it is worth R200 000, after 14 years it is worth R400 000 and after 28 years, by the time you turn 58, it is worth R1.6 million. If you cash in now, you effectively lose R800 000 of your retirement.
If you rather focused on paying off that R100 000 by cutting back on lifestyle expenses and living on a tighter budget, you could probably pay off your debts within five years with a payment of R2 900 per month. This would be even faster if you use bonuses or tax rebates to help with the debt repayment. Over five years at an interest rate of 25% you would spend R174 000 to settle R100 000 of debt. This is significantly less than the R1.6 million lost in retirement.
Also keep in mind that if you just settle debt with a lump sum and don’t learn to budget and live within your means, you will just end up back in debt a few years later and again be tempted to tap into your retirement nest egg. This is why so few people retire with enough money.
I am running out of retirement money. What can I do?
Due to my financial circumstances I have been drawing the maximum I am allowed from my living annuity. However, the balance is dropping every year and I am getting less money. What can I do?
This is one of the problems with taking out a living annuity. On retirement you have the option of either buying a guaranteed annuity which provides a fixed income for the rest of your life, or investing in a living annuity. A living annuity is linked to market growth and you can withdraw between 2.5% and 17.5% of the capital each year to provide an income. Many people opt for a living annuity because they cannot survive on the amount provided by a guaranteed annuity, yet this usually requires them to draw down more from the living annuity than the investment growth can support. Therefore, while they may initially have more money each month, the income starts to deplete rapidly.
The recommended withdrawal rate is a maximum of 5% as any amount higher than this means you start to deplete your capital. If you are withdrawing 17.5% of your capital each year, you will experience an income reduction within a year as you would require a market return of 17.5% to maintain the capital amount. This is virtually impossible.
For example, if you had R1 million and the investment returned 10% that year, you would have R1 100 000. But if you withdraw 17.5% (R192 500), you would reduce your capital to R807 500. Even if the investment grew again by 10% the following year, it would only grow to R888 250. If you now withdraw 17.5% you would receive an income of only R155 443 which is R37 000 less income than the year before. You now only have R732 807 of capital. This continues until you have virtually no income.
Over the last four years the returns from the market have been very poor, which will have had a further impact on the value of the fund. Your only option at this point is to find alternative income sources or cut back on your lifestyle so you can lower the amount you are currently withdrawing. You should contact the adviser who sold you the living annuity to do a proper cashflow analysis.
This article first appeared in City Press.