How to decide between a retirement annuity and a tax-free investment

22 Sep 2024

Whether you should put your money in a retirement annuity or a tax-free investment depends on your personal circumstances, The Financial Wellness Coach advises.

Question: I am 55 years old and was thinking of increasing my pension fund contribution at work to 15% from 10%. But having read your article, is it not a better idea to invest the 5% in a tax-free investment until retirement? I have never had one before and neither has my wife.

Answer: This is a really interesting question and in truth, there is no straightforward answer as the right solution will depend on your personal circumstances. I will flesh out the key features of both the products so that you can be in a better position to make the right call.

Investments

The retirement annuity is constrained by regulation 28, which restricts the amount that you can invest offshore and in equities. At the moment, the views of many of the better financial planning houses is not out of line with regulation 28. We are, for example, anticipating better growth in the local market than offshore over the next year, so the offshore restriction of 45% is not a factor.

Tax on growth

The growth in both investments will not attract income tax so there’s no difference on that front.

Tax on premiums

The real difference comes with the way the premiums and proceeds are treated. With the retirement annuity, your premium comes off your taxable income, so there is an immediate tax saving.

For example, if your tax rate is 30% and you want to invest R36,000 into a retirement annuity, once you take the tax discount into account, you would actually be investing R51,429 into a retirement annuity.

There is no tax break on the premiums that you pay into a tax-free investment.

I ran a comparison of investing R36,000 a year into a retirement annuity as well as into a tax-free investment. I assumed that the tax rate would be 30% and that the investment would grow by 10% a year. The table shows the results:

Retirement annuity vs tax-free investment

Retirement annuity vs tax-free investment

On the surface, it looks like the RA is way better than a tax-free investment. But there are variables that could change matters.

Your tax rate

If you have a low tax rate, the additional investment amount that you get because of the tax saving will be lower, so the gap between the two investments will be small. This is why I generally prefer to use a tax-free investment for a person starting out on their investment journey.

The expected returns

There will be times when the constraints of regulation 28 will result in weaker performance. If the tax-free investment gives a return that is 2% more than the RA, then its value would be R922,000 after 10 years, which is bigger than the RA.

Tax on proceeds

This is where the tax-free investment comes into its own. You do not pay any tax on the proceeds so you can effectively use it to draw a tax-free income. This is extremely valuable when it comes to structuring your retirement income in a tax-efficient manner.

With a retirement annuity, you are obliged to use two-thirds of the proceeds as an income. This income will be taxable.

I noted that your wife does not have a tax-free investment. If she is likely to have a lower tax rate than you when you retire, it may be an idea to invest some of the additional funds in her name.

So, to summarise, there is no easy answer here as it does depend on the investment environment and your tax rate. I recommend you speak to a financial adviser who can help you make the right decision. DM

Kenny Meiring is an independent financial adviser. Contact him on 082 856 0348 or at financialwellnesscoach.co.za. Send your questions to [email protected].

This story first appeared in our weekly Daily Maverick 168 newspaper, which is available countrywide for R35.

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