A tax-free savings account (TFSA) can help retirement fund members who bought living annuities to reduce their marginal tax rate, hence maximising their after-tax income, says Paul Hutchinson, a sales manager in Ninety One’s South African adviser team.
A minimum income rate of 2.5% a year must be taken from the living annuity, taxable at the individual’s marginal tax rate. Any income required in excess of this 2.5% can be drawn from a TFSA. This income is not taxable and therefore minimises the retiring member’s marginal tax rate, as long as the capital remains in the TFSA.
Drawing additional income from a TFSA means more money in your pocket for the same level of gross income drawn from the living annuity and the TFSA combined.
This is best illustrated by a simple example. Assume an investor has accumulated R1.8 million in his TFSA over the preceding 20 years and R7.5m in his pension fund, which he converts into a living annuity. He requires an annual income of R350 000, and his only source of income is his TFSA and living annuity.
Below are two simple scenarios based on the 2022 income tax tables (and ignoring the tax rebates):
- Scenario 1: In year 1 he takes the full R350 000 from his living annuity (a drawdown rate in year 1 of 4.67%). He will pay income tax of R74 314 and receive an after-tax income of R275 686.
- Scenario 2: In year 1 he takes the minimum 2.5% from his living annuity (R187 500) and the remainder from his TFSA (R162 500). He will pay income tax of only R29 250 and receive an after-tax income of R320 750 – in other words, a tax saving of almost R45 064 in year one and which, depending on the changing tax tables, is likely to escalate each year for as long as there is value in the TFSA.
Not only does this strategy reduce your marginal tax rate, but it also ensures that the capital in your living annuity continues to compound faster, as your capital is eroded more slowly than it would be if were you drawing more than the minimum.
Importantly, as with TFSAs, no income or dividend withholding tax is levied in the living annuity, and capital gains tax is not applicable in terms of current legislation –only income paid by the living annuity attracts tax. As is the case for TFSAs, retirement capital invested in living annuities therefore benefits from increased compounding returns.
Consider the estate duty
On death, it is preferable from an estate duty perspective to have depleted your TFSA (and other discretionary savings), while maximising the capital growth of your living annuity. This is because you may nominate a beneficiary or beneficiaries to receive the benefit on death, which in turn confers tax benefits on them.
Beneficiaries may choose to receive the benefit as an annuity, a lump sum (subject to tax) or a combination of the two. Both lump sum and annuity benefits are free from estate duty.
Bear in mind that disallowed contributions (retirement fund contributions in excess of a maximum allowable deduction) may be subject to estate duty where such contributions were made after 1 March 2015.