Tax Free Investment (TFI) vs Retirement Annuity (RA)Administrator
Tax Free Investment (TFI) vs Retirement Annuity (RA)
The end of the tax year is fast approaching – but there is still time to take advantage of some of the incentives the government has put in place to encourage savings. The introduction of the tax-free savings legislation last year has added an extra arrow to the quiver of tax-efficient options available to investors. Options are great, but having to choose often stops people from acting and can get in the way of our good intentions. If pressed to make a decision between a unit trust-based retirement annuity (RA) or a unit-trust based tax-free investment (TFI) product, which should you choose. These two investment vehicles both grow free of dividends tax, income tax on interest and capital gains tax and they are both long-term savings products. This means that because you are compounding all gains tax free, your investment value at the end of 30 years would end up roughly 45% higher than in a discretionary investment (assuming the investor saves R2 500 per month for 16 years and 8 months, at which point they have saved the R500 000 lifetime cap and can no longer contribute to their TFI; with a 13.3% total return).
The main difference between the two products is that an RA offers tax savings now, i.e. you pay less tax now because you make contributions with earnings on which you have not paid tax, but you will pay tax later, i.e. you defer paying tax. With TFI products, on the other hand, you use after-tax money to invest, but you pay no tax later; your withdrawals are completely tax free.
The benefit of using before-tax money in an investment such as in the case of the RA is that apart from deferring tax, the tax saving in a RA comes from paying a lower average tax rate on the benefits withdrawn from the RA at and after retirement, versus the tax saved on contributions. When comparing to a TFI product, the difference is that you have a future tax liability, whereas in a TFI your tax would already have been paid, but at a higher rate.
While the tax benefits of the RA and TFI are clear, it’s important to be aware of the restrictions before making a decision. RAs are governed by the retirement fund regulations, specifically Regulation 28 of the Pension Funds Act, which limits the exposure you can have to riskier asset classes, such as equities and offshore investments. In TFI products, there are no restrictions on asset classes but you can only invest in investments that charge fixed fees, which limits your selection.
Another critical point, is that you can only invest R30 000 per year in TFI products. This is the maximum limit for all TFI accounts in your name, across product providers. If your goal is to save for retirement, the maximum annual contribution of R30 000 in a tax-free savings account may not be enough to sustain your lifestyle, and if you over-contribute SARS will hit you with a hefty 40% tax penalty.
Access to cash may be another deal breaker: your investments in an RA cannot be accessed before the age of 55. You can access your TFI investment at any time. However, withdrawing from a TFI account impacts negatively on your lifetime investment limit of R500 000 – you cannot replace money that you have withdrawn.
Other important factors to consider is that the RA and are protected against the claims of creditors and do not form part of your insolvent estate. In the case of the TFI is could also be protected against the claims of creditors, depending if the insurance company offers the TFI as a life policy. In such a case it will be protected against the claims of creditors. The RAs are exempt from estate duty, whereas TFIs forms part of your estate and attract duty, although there are no executor fees if beneficiaries have been nominated.
Which product wins? From a retirement savings perspective, in most cases RAs offer the best tax deal. However, you need to be able to live with the restrictions described above. For long-term discretionary investments, it probably makes sense to put your first R30000 into a TFI product. Remember, however, that you will need to be disciplined and resist the temptation of withdrawing from your TFI account. You only get to enjoy the long-term compounding benefits if you don’t dip your hands into the cookie jar along the way.