CAPE TOWN - In this advice column Mikayla Collins from NFB Private Wealth answers a question from a reader who wants to know what the benefits would be of investing a lump sum into a retirement annuity at retirement.
Q: I am of retirement age, have worked for myself my entire life and never contributed to any retirement scheme. I have a lump sum to invest, which is my accumulated savings on which I now plan to retire.
I have been advised to invest this money into a retirement annuity, but I am unsure if this is the best approach. Why should anyone invest money that was not previously tied to a pension fund into a vehicle that will tie up the capital forever? I could invest it elsewhere to generate the same returns and have access to the capital at any time.
Are there tax or fee implications that would make putting the money into an RA a better deal, or is my adviser the one trying to get the good deal?
Contributing a lump sum of voluntary money to a retirement annuity has various advantages and disadvantages. Some apply to the retirement annuity itself, and some apply to the vehicle you choose for producing your income in retirement. For the purposes of your question, I have assumed this to be a living annuity.
First of all, the lump sum you contribute to a retirement annuity will be allowed as a deduction against your income. This is up to a limit of 27.5% of your remuneration or taxable income, or R350 000 (whichever is lower) in the current year. So initially, you will get a tax deduction.
The amount that exceeds this limit would however be carried forward and can be deducted against your income in subsequent years, or will be deducted against your annuity income that you receive from your living annuity at a later stage. So although you only get an immediate tax deduction up to the limit, you dont lose the full 27.5% allowance.
In addition, within the retirement annuity, and later in a living annuity, you will not pay tax on interest, dividends or capital gains.
However, within a retirement annuity there are restrictions as to how you may invest. These place limits on the amount you may have in equity (no more than 75%), property (no more than 25%) and offshore assets (no more than 25%). As you are close to retirement, it is unlikely that you would want to take on the risk of exceeding these limits anyway, but it is something to take into consideration. When you retire and move the funds to a living annuity, these regulations will not apply.
In addition to this, as you have mentioned, your funds would be tied up to a certain extent. You can only take one third out at retirement and the remaining amount must provide you with an income thereafter. Assuming you invest the remainder into a living annuity, you will only be allowed to withdraw between 2.5% and 17.5% per annum of the value, and this amount can only be reviewed once a year.
It is best to explain how this all works by way of an example. Let us assume that your accumulated savings are R5 million and your current year's taxable income is R500 000. Let us also assume that you intend to work for two more years and retire thereafter, and that your taxable income remains constant for the next two years.
If you contribute R5 million to a retirement annuity now you may deduct R137 500 (27.5%) against your taxable income, which will also move you from the 36% tax bracket into the 31% tax bracket. You will then carry over the disallowed portion of your contribution (R4 862 500) to the following year and repeat the process until retirement.
Over the next two years, you will not pay tax on any dividends, income or capital gains earned within the retirement annuity. This means that if you are able to invest in the same assets as you would in your voluntary portfolio, you will receive a higher after-tax return in the retirement annuity.
At retirement in two years time, you will have a remaining disallowed contribution amount of R4 587 500. This amount will be tax-exempt in future, whether you take it as a lump sum now or as income from your living annuity.
Keep in mind though that the lump sum allowed will only be one third of the value that your RA has grown to. So let us assume that your original R5 million contributed has then grown to R6 million, you will be able to take R2 million tax-free as a lump sum if you wish. The first R500 000 of that will be your tax-free allowance in terms of the retirement tables, and the other R1.5 million will reduce your previously disallowed contributions to R3 087 500.
Your living annuity income will then be exempt from tax until you have used up the entire remaining previously disallowed contribution. What will then be left in the living annuity is effectively growth and income earned over the period, and income tax will apply from that point forward, with your various annual rebates, exemptions and deductions applied.
Take note that any previously disallowed contributions made after March 1 2015 will be included in your estate for estate duty purposes but the portion that represents deductible contributions as well as any growth earned, will not be included in your estate.
If you are to pass away before retirement, the benefit in the retirement annuity must be paid to your dependants and/or nominees. This means that any person who is either a legal or factual dependent of yours, or any future dependants identifiable at the time of your death, will have a claim. This does not apply to the living annuity, as benefits will be distributed according to your will or beneficiary nominations.
The value of your retirement annuity would form part of your assets at divorce but once in a living annuity, it would be protected in this instance. Both the retirement annuity and living annuity are protected from creditors.
The above explanation is quite technical and there are many things to consider, but all other things being equal, you would not have to pay any additional tax by investing your retirement capital in a retirement annuity. You may fall into a lower tax bracket prior to retirement, your after-tax returns would be greater and you would not pay tax on capital growth. You would also receive certain protections in retirement vehicles that you would not receive in voluntary investments, and the amount included in your estate will be reduced to previously disallowed contributions.
This does however come at the cost of the various restrictions mentioned. The fees you pay your advisor should not be materially different for either option, but that would depend on the fee arrangement you have with your advisor, so there should be no benefit to your advisor in choosing one vehicle over another.
Mikayla Collins is a private wealth manager with NFB Private Wealth Management in Cape Town.