/ 21 September 2011

The impact of retirement caps on high earners

In his budget address, Finance Minister Pravin Gordhan proposed that from March 2012 all employees will be allowed to deduct up to 22.5% of their taxable income for contribution to retirement funds up to a maximum of R200 000.

While this may bring pension and provident fund rules in line, for the approximately 33 000* individual tax payers who earn more than R1-million a year, the R200 000 cap on tax-free savings will have a serious impact on their retirement provision.

National Treasury’s position that people earning over R1-million do not need tax breaks to save is a very short-sighted view in a country where savings are at a critically low level. The latest savings figures show that households are only saving at a rate of 1.5% of GDP while our total savings rate declined to 16.4%. International Monetary Fund research shows that a country needs to have a savings rate in the region of 25% of GDP in order to achieve an above average growth rate. South Africa remains critically dependent on offshore investment flows to fund our economic expansion. Savings are savings, whether it comes from the wealthy or the middle class.

This tax limit seems also to suggest that high income earners already have sufficient savings and do not need further incentives to save. As many advisers will attest, the amount a person earns has absolutely no correlation to the amount they save. In fact it is high income earners, who have the most access to credit, that tend to under save. The higher the earnings, the bigger the lifestyle.

It could be argued that a salaried person earning over R1-million a year would be at the peak of their career, past the age of 40. Like all South Africans, they would have under saved for retirement and it is at this latter stage of their careers that they would need to boost their retirement savings and take advantage of the tax-free savings up to 22.5% of income.

Jenny Gordon, senior legal adviser at Alexander Forbes says concerns have also been raised by the industry that if higher earning members reduce their contributions to retirement funds, the cost of running retirement funds for lower earning members could escalate due to the reduced levels of cost cross subsidisation. She adds that the cap of R200 000 assumes that a person contributes the same amount to a retirement fund each year over their entire lifetime, which is incorrect. People often have volatile income streams during their working years and they contribute more in years of prosperity and less in leaner years, which the cap fails to accommodate.

By limiting their tax-free savings, high income earners will be disadvantaged in providing for their retirement.

Independent financial advisor Janet Hugo says the industry, including the Financial Planners Institute, is raising questions about many of these retirement provisions which appear to be focusing on bringing in more tax now at the expense of a reduced pension savings base later. The industry is also looking for clarity around some of the provisions such as whether the cap of R200 000 also applies to retirement annuities or only to the combination of provident and retirement funds. There is also the question of whether a person who contributes above the tax-free percentage would be able to claim this back as a tax deduction on their lump sum at retirement. “More advisors should get involved in applying their minds to the proposals coming from Treasury and other government departments, like the Financial Services Board. They should find representative bodies and support them where they can”.

What should investors do?
These current proposals have not been finalised yet, however it does raise the question whether investors should still consider a retirement fund if they are not fully benefiting from the tax deduction.

Richard Mulholland of BOE Private Bank says although a taxpayer does not receive a tax-break on the contributions, there is still a significant benefit to saving within a retirement structure as there is no tax within the fund on interest income or capital gains tax.

For example if an investor saved R10 000 a month for ten years and received a 12% growth on the portfolio, at the end of the period he or she would have accumulated R2.3-million which would attract capital gains tax of R110 000 — equal to 11 months of saving. If 25% of the portfolio was invested in cash and bonds earning 6% a year, a further R50 000 of tax on interest income would be paid.

With questions being raised by the authorities around the tax treatment of many investment schemes like unlisted preference shares and high dividend income funds, there are limited tax-efficient investment options for high income earners outside of a retirement fund. A non-tax advantage is that a retirement annuity also enforces a savings discipline as the funds are not accessible.

Mulholland says high net worth individuals can also take advantage of a tailor-made share portfolio housed within a retirement annuity which would allow them to have a more aggressive approach to his or her investment as there would be no tax consequences when trading. If there were concerns about market valuations, an investor could theoretically move the portfolio to 100% cash with no capital gains or tax in interest income implications.

Mulholland does warn however one has to look at one’s entire financial situation as well as the costs of the retirement product and whether the tax benefit offsets those costs. Tax efficiency must be balanced by costs, income and growth of the investment.

Ultimately the best advice to follow is to start saving from your first pay cheque so you are not trying to play catch up 20 years later.
*Source:2009 Tax Statistics

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