Many graduates will enter the job market for the first time in January next year. How you spend your first salary is a trade-off between present and future needs. This article offers tips to three hypothetical new employees and is the second in a two-part series on how first-earners could allocate their salaries.
In South Africa, there is no ‘typical’ new graduate. Many new graduates are obliged to contribute to their parents’ or siblings basic income needs. Some have dependents of their own. On the other hand, others have a once-in-a-lifetime opportunity to build their capital and savings before the expenses that come with a young family.
At Rosebank Wealth Group we believe that financial freedom is a mental, emotional and educational journey and that the more informed you are the better off you will be. We are not in the business of advising our clients to buy the last year’s hero fund, but to partner with clients in their efforts to reach financial goals using the most effective solutions.
- Some general rules:
- If you learn to live modestly, you can save more. Many readers will be aware of ‘Julia’ a guest on Bruce Whitfield’s Money Show on 702 who has become the poster-girl of saving and investing. In her pre-children years, she paid a third of her income in tax, saved a third and lived on a third. This is an ambitious savings target and requires a lot of discipline as well as a relatively high starting salary.
Two of our case-study graduate earners (Caroline and Themba) have been left with disposable income of about 50% of their gross income, while Karishnee is left with just less than 30%.
- Understand the benefits of saving through a retirement fund: All contributions to retirement irrespective of whether they are made to pension funds, provident funds or retirement annuity (RA) funds qualify for a tax deduction of up to 27,5% of taxable income (up to R350 000 a year). Ask your financial adviser to explain the impact of this benefit to you so that you have a good grasp of your after tax income under different scenarios.
- Be wary of signing an RA contract with a life insurer: If you are planning to take time off to do a post graduate degree, or work overseas for a work transfer for an indeterminate period, you could be liable for ‘contract breakage fee’ of up to 15% of the money you have invested to date in an RA sold by a life insurer. Some life insurers offer clients ‘lock-in rewards’ in the form of higher payments. However, the value of these benefits is difficult to quantify. Avoid uncertainty and penalties by signing up with an ‘invest as you go’ unit trust company. At the outset, ask your financial adviser to help you avoid products with exit penalties.
- Tips on buying life insurance, critical illness insurance and disability insurance
Insurers make money by selling clients insurance policies after carefully assessing the risk and pricing policies accordingly.
- Insurance premiums are generally a grudge purchase. Remember that pay-outs are calculated on what policy holders are willing to pay, not the real cost of income replacement over a lifetime.
- As a general rule, we believe that ‘term’ insurance is overpriced, relative to ‘all life’ insurance. In our experience, underwriters do not price correctly for term cover (life cover that ends at retirement age) and for not much more you can get whole of life (life cover that pays out when you die). Ask your financial adviser to get quotes on both of these options so that you can make an informed choice. Make sure your adviser compares the premium for term and all life policies over a range of contribution dates.
- Be honest when answering insurers’ questions. One of the basic rules of insurance contracting is that you have to be honest. If you smoke, your premiums will be about 25% more expensive but you will be paid out if you have a claim.
- Be wary of cheap premiums and ‘specials’. Cheap premiums usually translate to reduced benefits. The competitive price offered by way of special deals is often clawed back by higher escalation rates. Insurers have to square their books somehow.
- You can reduce your premiums by taking on some of the risk yourself: If you know you are a ‘good risk’, back yourself. Choose an insurer that rewards you for taking precautions and being healthy. You can also reduce premiums by choosing options where you increase waiting periods before you claim.
- When comparing quotes it is important to compare like with like. Policies can differ according to:
- The number of diseases covered. Some policies list the diseases that they cover; limiting the covered diseases to 36 for example. If you get a rare terminal illness which is not on their list, you will not be covered.
- Some critical illness benefits are paid on first diagnosis, some are severity based, and others pay out in regular pre-quantified amounts.
- Some policies premiums are quoted on the basis that premiums remain level, other premium increases are age-related (and get more expensive as you get older) while others have a built-in escalation rate.
- Whether you insure your ‘own occupation’ or ‘any work’. Ask your financial adviser to guide your through this important difference. Insurers use a methodology called the ‘Activities of Daily Work Benefits’ to measure physical and mental capacity of those occupations that don’t qualify for the ‘own occupation’ definition.
- As a general rule, buy only what you need. As a young person entering the job market, your most valuable asset is your future income stream. Priorities include critical illness cover and disability cover. For most people, life insurance is only necessary if you have dependents.
- If you already have a serious illness. It is still possible to buy life, disability and critical care insurance. However, the premiums might be higher to reflect your added risk or the insurer may elect to exclude benefits specific to your condition. Be aware that some insurers underwriting ‘added risk’ clients might insist on selling life, critical illness and disability polices together.
- Money paid to you by an insurer as an insurance benefit is tax free. It can be used in any way you like. The benefit might help you pay a lump sum off your home loan, enable you to stop working or contribute to the payment of your medical expenses.
- Ask your independent financial adviser for advice to ensure that you get the best deal. We asked a number of insurers for quotes before writing this article. The range of prices and benefits offered by insurers to our three new graduates differed widely, underlining the importance of dealing with an experienced adviser.
Case study 1: Caroline
Caroline, age 26, is a single mother and lives with her parents. Her parents have offered to look after her three year-old daughter while she is at work, and said that she need not pay them rent; a big saving for her. She has been employed as an engineer and will earn R20 000 a month before tax. Her employer does not have a pension scheme or medical scheme. She wants to save as much of her salary as she can, in a unit trust-based RA, while her daughter’s expenses are still relatively low. Caroline will be responsible for her daughter’s medical scheme contributions and her own, but not her parents.
Retirement annuity: Caroline’s pre-RA tax rate would be in the second salary band of the SARs tax table (R189 881 – R296 540) and 26% of her salary. However, if she contributes R66 000 of her annual salary to an RA, her tax rate drops to the first band of the tax table and she is liable to pay SARs only 18% of her salary. Note that in practice Caroline will only get this benefit once a year when she gets her money back from SARS.
Medical scheme membership: Caroline should expect to pay between R1 900 and R2 000 in premiums for a ‘core’ medical scheme which offers hospitalisation and limited day to day benefits. We found one that has a premium of R1 956.00 for the main member and a child dependent.
Life insurance and critical illness insurance: Caroline should expect to pay about R400 per month to a whole life insurance policy and R300 to a critical illness policy. She has decided not to buy disability insurance as she will be salaried for the next few years.
Caroline’s income after her payment to SARS and RA contribution
Caroline’s annual salary is R240 000. If she contributes 27.5% of her salary (the maximum amount) to an RA, this will be R66 000 per annum and her new taxable income will be R174 000. She will have to pay tax amounting to R31 320 (R174 00 x 18%), leaving R142 680 or R11 890 per month.
Table A: Caroline’s income after insurance and medical scheme membership.
Case study 2: Themba
Themba, age 25 is single and will be employed as a high school math teacher in a private school. He will live at home and has offered to contribute to the education of his brother and sister, aged 14 and 16. He is expecting to earn about R184 000 per year. He needs a medical scheme with good cover as he has Type 1 Diabetes.
Retirement annuity: Themba wants to contribute to a unit trust based RA, but it has to take his other expenses and obligations into account; he thinks he can afford R3 000 a month or R36 000 a year. He has nominated his siblings as his beneficiaries, so that if he dies, they get a lump sum to help them pay for future education.
Medical scheme membership: Themba has lived with Type 1 Diabetes since he was a child and knows how important it is to manage his illness. His doctor has recommended that he join a scheme with a Diabetes Management Programme managed by the Centre for Diabetes and Endocrinology. Premiums for options with this level of cover are about R2 300 per month.
Life insurance, critical illness and disability cover: Themba was shocked to discover the cost of life, critical illness and disability insurance as a policy holder with Type 1 Diabetes. He decided to do without cover and spend on a medical scheme that will help him stay healthy.
Funeral cover: Themba knows that if he dies, the cost of his funeral will be a big expense for his family. He has allocated R100 per month to a funeral insurance policy.
Themba’s income after his SARS and RA contribution
Themba’s annual salary is R184 000. If he contributes R3 000 a month to an RA, this will reduce his taxable income to R148 00 and will pay tax of R26 820. His after-tax income will be R122 180 or R10 182 per month.
Table B: Themba’s income after payment for medical scheme membership and funeral insurance
Case study 3: Karishnee
Karishnee, age 25 is single and has no children. She has just graduated as a doctor and over the next three years she will have to do two internship years and a community service year as an employee of the Department of Health. She wants to save as much for her retirement as possible, but her priority is to save to join a private medical practice, the ‘joining fee’ of which is R500 000, to pay for existing medical equipment and access to the patient base. When she has met this obligation, she will re-evaluate her RA commitments.
She does not want life insurance as she has no dependents. She wants to pay for critical illness insurance from her first salary, but wait for when she is self-employed and has no leave allowance before she pays for disability cover. She is healthy and wants a minimum entry level medical scheme which gives her a choice of medical practitioners and hospitals.
She will need to buy a car as her work will require her to work late hours and in a range of different hospitals; her bank has offered her a vehicle financing arrangement and she will be paying off her car at R3 000 per month. Her starting salary will be about R50 000 before tax.
Retirement annuity: With a gross salary of R600 000 a year, Karishnee falls into the fifth salary band (R555 601 – R708 310) and is liable for tax at the rate of R149 475 + 39% over R555 600. To fall into the fourth salary bank she would have to contribute at least R44 399 (R3 699 per month) to an RA. We would propose that she should contribute R5 000 to an RA.
Medical scheme membership: Karishnee will contribute R1 600 to a medical scheme every month.
Insurance policies: Karishnee’s first priority is to pay for a critical illness insurance policy. When she is self-employed, she will re-evaluate and contribute to a disability policy.
Other savings: Karishnee wants to save R500 000 over three years to pay for the GP joining fee. A good vehicle for this saving would be a monthly investment into a unit trust in the Multi Asset Variable category. This category of unit trusts is permitted to invest in a flexible combination of investments in the equity, bond, money and property markets according to the investing environment. A contribution of R13 700 per month at zero performance will enable a savings of R493 200 over three years.
If Karishnee wanted to save more ‘non-RA’ money over a longer time frame, it would be appropriate to consider a tax-free savings account.
Karishnee’s income after her payment to SARS and her RA contribution
Karishnee’s annual salary is R600 000. If she contributes R5 000 a month to an RA, this will reduce her taxable income to R540 000 and she will pay tax will pay tax of R143 859. Her after-tax income will be R396 141 or R33 011 per month.
Table C: Karishnee’s annual income after allocation to insurance, medical scheme and additional savings
These three case histories show how financial advisers have to take your priorities into account while striving to ensure that you become financially independent. A good financial adviser, working with you and with your best interests at heart can help you wade through the plethora of complexity and help you get the most out of your hard won salary.