Retirement-fund tax is gone. It has not merely been reduced, it has been abolished. Retired. At a time when only a tiny minority of people can afford to retire without a plunge in living standards, Finance Minister’s Trevor Manuel’s ending of a decade of taxation of retirement savings should be celebrated by those far-sighted enough to plan for retirement.
Retirement-fund tax (RFT) is paid by retirement funds on the interest and rental income earned on the funds’ investments.
First introduced in 1996, when it was set at 17% of interest and rental income, RFT has been a powerful disincentive for saving for retirement.
A reluctance to make additional contributions towards your employer-sponsored retirement fund, or to purchase a retirement annuity if you do not belong to a retirement fund, was perfectly understandable. There was considerable uncertainty regarding how much of your savings would land in government coffers in the future.
RFT reached a high of 25% from 1998 to 2002. Since then it has been gradually reduced, but, until now, there was no guarantee that another hike was not lurking around the corner.
Tax rate
In its swan-song year, RFT was at its lowest at 9%, high enough to reduce a typical retirement fund’s annual return by 0,3% a year. Not much, you say? That’s because, as behavioural scientists will explain, we suffer from a severe case of hereditary myopia — thanks to our ancestors’ short life spans, we are simply unable to focus far enough ahead.
Over a 35-year working life of contributing to a retirement fund, a 9% tax will reduce your income in retirement by 5%. When that day comes, when your employer declares you no longer employable (with the traditional fanfare) and when your only source of income is the money you saved while you were considered useful, an additional 5% will be cause for celebration indeed.
Over the past decade, the average rate of RFT was just higher than 20%, enough to gnaw away more than 10% of your retirement contributions saved over 35 years.
The effect is even more significant for a person changing jobs, who must decide what to do with the withdrawal value paid from his previous employer’s retirement fund. If a 30-year-old chose to preserve the capital by transferring it to his new employer’s fund, a 20% tax would eat away 16% of the sum by retirement at age 60. With the tax abolished, this 16% will instead be in his pocket at retirement.
Given the retirement-fund reform process on which the government embarked in 2002, which identifies woefully inadequate retirement savings and lack of preservation as major challenges, the abolishment of RFT is a vital clue to the government’s commitment to the process.
Preservation is the habit of ignoring the temptation to spend the withdrawal value paid from one’s retirement fund when changing jobs.
Saving
With income tax, capital gains tax and a proposed new dividends tax payable on investments outside retirement funds, these funds are the most tax-efficient savings vehicles around. (Although it remains to be seen whether retirement funds will be exempted from the dividends tax, such an exemption seems likely.)
Our advice to fund members is to increase their contributions to the maximum tax-deductible limit of 7,5% of salary. From March 1 we all pay less tax due to the reductions in personal income tax Manuel announced. Those contributing at lower rates should take advantage of this tax windfall and increase their contributions. For those fortunate enough to be paid bonuses, after settling debts, allocate as much as possible to your retirement fund.
Retirement is often portrayed as our golden years. However, unless you make adequate savings now, like a poor alchemist’s dream gone horribly wrong the gold may turn to copper. Given the favourable tax regime, now more than ever, you should do your retirement saving through your retirement fund or by purchasing a retirement annuity.
The table below shows how much you need to contribute (your employer’s contributions plus your own) as a percentage of your salary in order to be able to retire at age 65 with a single life pension equal to 75% of your salary just before you retire, with expected — but not guaranteed — future CPI increases.
Contributions as a percentage of salary
Age start saving: 25
Male: 16%
Female: 17%
Age start saving: 30
Male: 19%
Female: 20,2%
Age start saving: 35
Male: 23%
Female: 24,5%
Age start saving: 40
Male: 28,6%
Female: 30,5%
Assumptions: Real return 4% a year, salary increases 2% a year real up to age 50, 1% a year real thereafter, with profit annuity at 3,5% interest, no spouse’s pension, no guarantee period
Ken Schumann is employed by Old Mutual Actuaries and Consultants