Death and (Deferred) Taxes

11/03/2019
Posted in Blog
11/03/2019 Mduduzi Luthuli

Sometimes, we in the personal finance game are good at telling you what to do but not why. So much of our advice is obvious: Save your money, don’t take on high-interest debt, insure your assets etc.

It occurred to us, however, that we’re always telling people to take advantage of their pension funds and retirement annuities, but it’s far from obvious why this is such a good idea. If you don’t want to tiptoe through the semantics with us, we completely understand. The take-home message is….

Unless you make enough money to max out all your tax-advantaged (retirement) accounts, it rarely makes sense to do any investing outside them.

Let’s explore why.

Tax Deferred

An account is tax-deferred if there is no tax due on income earned in the account. The ability to defer taxes on the returns of an investment benefits individuals in two different ways.

The primary benefit comes in the form of tax-free growth. As an alternative to paying tax on the current returns of an investment, taxes are paid only at a future date, allowing the investment to grow without current tax implications.

The secondary benefit of tax-deferred investments is that they often occur during working years when earnings and taxes are most often higher than earnings and taxes during retirement. It is important to note that “tax deferred” is not the same as “tax exempt,” which refers to the absence of applicable taxes. Remember, tax deferral means taxes are assessed but payment is delayed; tax exempt means taxes are never assessed on the investment in the first place.

As investors move into higher and higher tax brackets, tax-deferred investments become more and more advantageous. The use of a tax-deferred investment account is most often a wise decision when you are in a higher tax bracket now compared to the income tax bracket you anticipate being taxed at in the future when you will be taking withdrawals/ income.

Investment Flexibility

This no-tax situation allows you the freedom to be more flexible in your investment decisions.

Some people hold on to a stock or fund because they don’t want to pay taxes on the sale, only to see the value of the investment drop like a rock. But within a tax-advantaged account you don’t have to worry about how various types of investments are taxed, because you don’t have to pay annual taxes on it and everything is taxed as income when you take the money out. You’re free to select the most appropriate investments, and don’t need to worry about the impact on your tax bill until retirement.

Free Money

These tax-advantaged accounts are like free money from the government, year after year. It’s similar to an employer matching your retirement contribution rate on their pension fund, although admittedly not as lucrative.

If you’re not maxing out your annual retirement contributions because you can’t afford to, or because you’re building up an emergency fund or saving for a near-term cash outlay like a house or car, or because you’re paying down debt, that’s perfectly reasonable.

But if you’re putting investments (or cash) in a taxable account for an unspecific future goal while your retirement contributions languish unfulfilled, you’re just throwing away money.

Semantics

Contributions to retirement accounts are tax deductible, within certain limits. The maximum tax deduction you may make in a tax year is limited to the greater of 27.5% of taxable income or remuneration from your employer, subject to an annual ceiling of R350, 000.

On 1 March 2016, the tax deductions for retirement savings increased from 15% to 27.5% – which means you can now save more for retirement and get back more from SARS. If you contribute more than the limits, your excess contributions can be used to decrease the tax you may need to pay on any cash lump sum you take before, or at retirement age, or to reduce the taxable portion of your living annuity income in retirement.

Contributions above this limit made directly by your employer are also taxable as a fringe benefit in your hands, but the contributions are also deductible in your hands too, subject to the annual limits. Excess contributions in one year can also be carried over and deducted in the next year. Even if you are a member of a company pension or provident scheme, you can set up a retirement annuity to supplement your existing contributions, which are tax deductible.

If you are contributing to a modern retirement annuity (RA), you can stop and start your RA payments as often as you want, and the investment is held in your name (even if you get it through an employer).

Final Thoughts

You need to keep a sharp lookout for ways to protect your savings from taxes and inflation. Don’t pay taxes now amid a tight financial situation. Make your decision using math – not emotion. Make sure to maximize contributions now to secure your retirement later. Contribute early and often so you can watch your savings grow!

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