This may be the last year in which you can take advantage of Finance Minister Trevor Manuel's "special offer" to reduce your taxable income while saving for retirement.
Last week, President Thabo Mbeki announced that the government is proposing to introduce a national retirement scheme, which will provide a basic pension equal to about 40 percent of final salary.
Details are to be spelt out by Manuel on Wednesday when the minister delivers the government Budget to parliament.
Mbeki's proposal seems to be based on a document prepared by the Department of Social Welfare as part of the retirement reform process, which has now been under way for a number of years.
In the document it is recommended that contributions to the government's proposed scheme be made compulsory, which, in turn, means that no tax incentives need be given to encourage you to save for retirement via private sector vehicles.
If the Department of Social Welfare recommendations are fully accepted by government (and Manuel will tell us on Wednesday), then this may well be the last year in which you may be able to claim contributions to a retirement fund against taxable income.
February 28 is the deadline for the second payment of provisional tax. It is also the cut-off date if you want to reduce your tax liability for the year. In both cases, you have to do your tax sums before the end of the tax year, which is February 28.
Currently, tax laws allow you to deduct limited amounts from your taxable income to fund your retirement. It is not that you do not pay tax on these deductions, you do - but only when you draw the money as a pension when you are in retirement. But then you will get a favourable rate of tax on any lump sum you are entitled to take from your retirement savings. And don't forget that you pay less tax if you are 65 or older.
By saving in a retirement savings vehicle, you are effectively deferring the payment of tax until you retire. The money you don't pay in tax is also earning investment returns until you withdraw it as a pension. So, you get a double advantage ( See table).
The three main ways to save for retirement and take advantage of the tax incentives are through:
- Employer-sponsored pension funds. These include both defined contribution and defined benefit pension funds, but exclude provident funds.
- Umbrella funds. There are open umbrella funds and restricted membership umbrella funds:
* Open umbrella funds. These funds are mainly administered by life assurance companies. In effect, your employer signs up on your behalf and on behalf of other employees. Your employer becomes a participating member and passes on both your contributions and any contribution the employer may make to the fund.
* Restricted umbrella funds. Membership of a restricted umbrella fund is normally limited to members of an industry group or a trade union.
- Retirement annuities (RAs). These are, in effect, life assurance endowment policies that have tax advantages. If you are a member of an employer-sponsored and/or umbrella fund, you may deduct from your taxable income your contributions to the fund up to a maximum of 7.5 percent of your taxable pensionable income. Pensionable income excludes such things as motor vehicle allowances.
If you are saving money in an RA, you may deduct from your taxable income the contributions you make to that RA - up to a maximum of 15 percent of your non-retirement funding income. (Taxable income is income that is subject to tax after you have deducted the exemptions from your taxable gross income.)
RAs can be used by people who are or who are not members of pension or umbrella funds.
You should sit down at the beginning of each year (with a financial adviser if you are not sure of how all this works) and calculate the maximum that you can contribute to retirement savings vehicles to take full advantage of how much you can contribute on a monthly basis.
Very few people who are members of employer-sponsored pension funds or umbrella pension funds actually contribute the full 7.5 percent. However, most funds permit you to make additional voluntary contributions on a monthly basis.
If you can afford it, you should always make the maximum contribution before deciding to use RAs, because this is likely, by far, to be the most cost-efficient way to save any additional money because pension funds tend to have lower costs.
Obviously, however, many people cannot predict how much they may earn in a year. For this reason, you are allowed to top up any contributions to the maximum tax-deductible limit with lump sums.
The best time to calculate any top-up is in February, the last month of the tax year, when you have a far better idea of your income and how much you can contribute. Very few retirement funds allow you to inject an additional lump sum amount of cash into the fund in the last days of February. However, you can take out an RA or add a lump sum to an existing RA.
Effectively, if you are paying the top marginal tax rate of 40 percent and you contribute 15 percent of your non-retirement funding income to an RA, you can claim it as a deduction. In effect, Manuel is adding 40 percent to the amount you contribute to your retirement savings.
This is a good deal, but time is running out if you want to take advantage of Manuel's "special offer".
Health warning
- Be aware of the cost structures of a retirement annuity (RA). RAs are offered in three different types of product wrappers:
* Life assurance policy. A life assurance RA will in most cases come with a contractual term for a single-premium payment and with a contractual premium for a recurring premium.
If you break or vary the contract, you will be penalised by as much as 30 percent of your investment. Remember, you do not have to take out a contract until the age of 55. This is only a requirement of the Income Tax Act, which precludes you from maturing an RA before the age of 55.
Some life assurance products also have high costs. You can, however, get capital-guaranteed investments.
* Unit trusts. These products can be accessed directly and have the lowest cost structures. There are no contractual restraints. You will have to select from the unit trust funds of one unit trust management company.
* Linked investment service products. These products offer a range of funds offered by various unit trust management companies. They are similar in structure to products offered by unit trust management companies, but they provide you with more choice at an additional cost but without contractual commitments.
- You need to compare costs on a reduction-in-yield basis. The best way to do this is for your financial adviser to calculate how much you will pay in total in premiums and then calculate the effect that the costs will have on this amount over the contract period.
- Take out an RA as early in your working life as possible because the longer you have it, the greater the tax advantages, both in the build-up to retirement and at retirement.
- An RA must only be used as a vehicle for retirement savings. You can't draw money from an RA before the age of 55 (the earliest retirement age recognised by the South African Revenue Service). At retirement, you will have to use a minimum of two-thirds of the RA to buy a monthly pension.
* Never take out an RA that matures after you turn 55, unless you are over 50 - and then limit the term to five years. The policy can be extended without incurring a penalty up until the age of 69, at which age you are obliged to mature your retirement savings.