Retirement savings vehicles Do you understand the difference? Edition Two November Author: Tania Theron

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1 Author: Tania Theron Retirement savings vehicles Do you understand the difference? We often see articles urging us to save for retirement in order to live a comfortable life the day we retire. Do investors really understand the various retirement fund options which are available to them and how they each differ? Some investors do, some investors simply appoint financial advisors that can guide them in the right direction, but most investors do not have adequate insights into the optimal retirement strategy. This article will empower you with valuable information regarding the most frequently used retirement fund savings vehicles available in the industry. The purpose of retirement savings vehicles is to provide employees or selfemployed individuals and their dependents with an income after retirement. The different types of retirement savings vehicles available to investors are: 1. Provident Funds, 2. Pension Funds, 3. Retirement Annuity Funds, 4. Preservation Funds, and 5. Life and Living Annuities. The main difference between these retirement savings vehicles is how you receive the fund benefit at retirement and thereafter and the tax treatment thereof. In most cases, investors can via all these retirement savings vehicles invest in the same underlying investment products (Some pension and provident funds might have specific fund rules regarding their investment products). It is therefore just the vehicles that differs. This means that whether you contribute towards a pension fund or a retirement annuity, your underlying investment product or solution can be exactly the same. Below is a description of each retirement savings vehicle, their differences and similarities. We hope the overview empowers you to make more informed investment decisions for your nearing retirement. 1

2 PROVIDENT FUND You are allowed to withdraw the full savings in cash before or at retirement from a provident fund, whereas with a pension fund, the maximum cash withdrawal allowed before or at retirement is restricted to one third of your savings. 1. What is a provident fund? A provident fund is a savings account comprised of contributions made by you during your working years, in addition to the contributions made by your employer. The monthly contribution is calculated as a percentage of your salary. There has to be an employer-employee relationship. >55 subject to rules of the fund, or earlier in case of disability. The total value can be withdrawn at retirement, permanent disability, death, resignation or retrenchment (e.g. before retirement). None of the current or arrear contributions are tax deductible for the employee. The employer may deduct 10% of the approved remuneration but in practice up to 20% is allowed. Retirement benefit: Upon retirement, commutation of any annuity, retrenchment or death, the first R315,000 is tax free (plus any contributions which did not previously qualify as a deduction less any lump sums previously allowed). The taxable portion of the lump sum is calculated as follows: Taxable Income (R) Rate of Tax (R) % of taxable income % of taxable income R % of taxable income and above R % of taxable income Withdrawal benefit (e.g. withdrawal, divorce or transfer): the tax free portion is R22,500. The taxable portion of the withdrawal benefit is calculated as follows: Taxable Income(R) Rate of Tax (R) % of taxable income % of taxable income % of taxable income and above % of taxable income 2

3 A survey of working metro households showed that 62% of respondents had funeral policies. However, only 46% were members of pension or provident funds and only 27% had retirement annuities (RAs), while 45% had no pension, provident fund or RA provision at all. 5 th Edition of Old Mutual savings and investment Survey. There are indications that provident funds might disappear in the future. The reason is that the main attraction of a provident fund, namely to be able to make a 100% lump sum withdrawal at retirement, will no longer be available to investors. All future contributions will be subject to a maximum withdrawal of one-third, as is the case with pension funds and retirement annuities. PENSION FUND 1. What is a pension fund? A pension fund is a retirement savings pool established by an employer. You, as the employee, as well as your employer contributes to this savings pool. These accrued contributions will provide you with an income (a pension) once you reach retirement age. There has to be an employer-employee relationship. >55 subject to rules of the fund, or earlier in case of disability. 1/3 of the total savings value may be withdrawn on retirement or in the case of permanent disability. If the total value of all retirement benefits per pension fund is less than R75 000, the full amount may be withdrawn as a lump sum. The balance (i.e. the other 2/3 of the total savings value) must be used to purchase a life or living annuity. The total savings value can be withdrawn at death or resignation, retrenchment, winding up of the fund or dismissal. Current pension fund contributions by the employee may be deducted to the greater of 7,5% of remuneration from retirement funding employment, or R Any excess may not be carried forward to the following year of assessment. A maximum of R1 800 per annum may be deducted as arrear pension fund contributions by the employee. The employer may deduct 10% of the approved remuneration but in practice up to 20% is allowed. The tax on lump sums at retirement, disability, death and withdrawals at resignation or retrenchment is exactly the same as provident funds. 3

4 RETIREMENT ANNUITY (RA) A retirement annuity (RA) allows investors the flexibility to contribute on a regular basis, to interrupt contributions for a period and to stop contributions at any stage. Some life companies might charge a penalty for stopping the contributions. 1. What is a retirement annuity? An RA is a long term investment tool used by self-employed investors. You may contribute monthly or in lump sums until you reach retirement. RAs can also be used by employed persons as a supplement to their pension and provident fund contributions. No employee-employer relationship exists. As an RA does not make monthly, quarterly or annual payouts, on retirement, you have a choice to transfer your savings to a guaranteed life annuity (an annuity that provides income for life) or a living annuity. By choosing a living annuity you can manage the income you receive (between 2.5% and 17.5% of the savings amount each year). The cash benefit from a RA falls outside your estate, so for example, if you die and are insolvent, your benefit is paid to your family rather than your creditors. >55, except in case of disability it can be before age 55. Fund rules can determine maximum age. 1/3 of the total savings value may be withdrawn on retirement or in the case of permanent disability. If the total savings value of all retirement benefits per retirement annuity is less than R75 000, the full amount may be taken as a lump sum. The balance (i.e. the other 2/3 of the total savings value) must be used to purchase a life or living annuity. Withdrawals (e.g. retrenchment or resignation or winding up of the RA fund or dismissal) before age 55 is not allowed, unless the paid up value is less than R Current RA contributions by the employee are tax deductible to the greater of 15% of non-retirement fund income, or R3 500 less allowable pension fund contributions, or R Any excess (e.g. contributions above 15% of non-retirement fund income) may be carried forward to the following year of assessment. 4

5 A transfer from a preservation fund to an RA fund is not allowed. However, a transfer from a pension or provident fund to a RA is allowed The tax on lump sums at retirement, disability, death and withdrawals at resignation or retrenchment is exactly the same as pension and provident funds. RAs are currently not subject to Capital Gains Tax. Interest and dividends are not taxed within a RA. On death, any benefits paid out by way of RA or lump sum are free of estate duty. The tax implication for government employees are different and are not set out in the article. PRESERVATION FUND 1. What is a presevation fund? Few individuals remain with the same employer for the whole of their career. If you resign or are dismissed, you may transfer your provident or pension fund benefit to a preservation fund. These vehicles are specifically designed to safeguard your retirement savings. Members of pension funds must transfer to a pension preservation fund and members of provident funds to a provident preservation fund. No additional contributions are allowed to payments to preservation funds. When retiring from a preservation fund, legislation requires that at least two thirds of your retirement savings be invested in a living annuity or a life annuity. You can retire from a preservation fund at any age after 55 (no maximum age) regardless of the transferring fund s retirement age. 3. Lump sum Withdrawals and Tax Implications: The same rules regarding lump sums, taxable and tax free portions apply as for pension and provident funds depending on which fund the member belonged to. I.t.o disability, if a member has reached 55 years, he may become entitled to a retirement benefit from the preservation fund, even though he is still employed. Exempt from dividends tax which comes into effect 1 April Transfers are only allowed on retrenchment, resignation, dismissal or winding up of the fund not on retirement. 5

6 LIVING AND LIFE ANNUITIES Advantages: Flexibility. You decide where to invest your money and you choose your own level of income. Disadvantages: You carry the risk of poor market performance there are no guarantees. There is a risk of outliving your savings i.e. longevity risk. This is the risk of living much longer than expected and drawing too much income early on. 1. What is a living of life annuity? When retiring from a pension / provident fund, a preservation fund or an RA, legislation requires that at least two thirds of your retirement savings be invested in a retirement savings vehicle such as a living annuity or a life annuity. The main differences (Source: Securewealth) between a living annuity and a life annuity are as follows: Your beneficiaries can continue to receive the benefits due under your living annuity on your death. In the case of the life annuity payment of benefits ceases on your death, or if you so arrange it, the death of your spouse. You are allowed to change the level of income you receive from a living annuity once a year (a minimum of 2.5% and a maximum of 17.5%) to suit your particular circumstances whereas the annual income paid from a life annuity is fixed or escalates at a fixed rate every year. With a living annuity, your annual income as well as any capital your dependants may receive at your death depends on the growth (positive or negative) realised on the savings in your living annuity. The growth on your capital is not guaranteed and fluctuates with the markets. With a life annuity you receive a guaranteed income until death. With a life annuity the benefits that you receive for the remainder of your life is determined by interest rates at the time of your retirement. If inflation increases significantly during the remainder of your life, your benefits will be severely eroded. One can opt to invest in a living annuity from the age of 55. Lump sum withdrawals are not allowed. Capital withdrawals you receive until death might be taxed according to your marginal tax rate (SARS tax tables) if it was not previously taxed under a pension, provident or an RA withdrawal. Exempt from dividends tax which comes into effect 1 April The interest portion will be taxed on withdrawal accordingly to 6 your marginal tax rate.

7 NEW DEVELOPMENTS The Institute of Retirement Funds submits that retirement funds play a primary role in savings as it is the most important savings vehicle for the majority of retirement fund members or formally employed citizens in South Africa. Therefore the IRF supports the policy that all changes to retirement funds should stimulate and encourage the savings culture of retirement fund members. The following proposals were raised in the February 2011 Budget Speech but were not dealt with in the draft Taxation Laws Amendment Bill (TLAB) 2011 and have still not been dealt with in the final TLAB: Employees will face a "fringe benefit tax" on company contributions to their pension and provident funds. 22.5% (see details below of what is currently allowed) of your income for contributions may be allowed as a deduction to pension, retirement annuity (RA) and provident funds. This means that you may get a lot more tax back if you increase your retirement savings. The maximum tax saving on contributions will be reached when the person s taxable income, including the employer s contribution as a taxable fringe benefit, reaches R because government is putting a cap of R200,000 on contributions deductibility. SUMMARY The South African Government is not only protecting individual s retirement savings by restricting their lump sum withdrawals but also giving them preferential tax rates when they retire, e.g. the tax threshold for age 75 years and older are R , for 65 to below 75 it is R compared to the R59,750 for below 65. We want to encourage you to get actively involved in managing your retirement savings. Contact your financial advisor to assist in determining the best vehicle for your retirement savings. 7