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Does it make sense to contribute after-tax money to a pension fund?

The pros and cons of contributions beyond the R350 000 cap.

Since March 1, 2016 tax deductible contributions to pension funds, provident funds and retirement annuities have been capped at R350 000 (or 27.5%) per annum.

While high-net-worth individuals who previously contributed more than R350 000 to these vehicles may continue to do so, excess contributions will effectively be made with after-tax money and their take-home pay will reduce.

Speaking at the Tax Indaba, Gary Eaves, head of emerging market tax affairs at the Old Mutual Group, said for people close to retirement who would like to save more in a retirement fund this was bad news, but from a broader socio-political perspective, the regulatory change was the right thing to do.

Essentially, the change was part of government’s redistribution process, whereby high-income earners received less of a tax shelter while lower-income individuals received more tax benefits, he argued.

But does it still make sense for high-net-worth individuals to contribute more than R350 000 per annum to a retirement vehicle if they lose the upfront tax benefit or should they rather use discretionary investments?

Wouter Fourie, CEO of Ascor Independent Wealth Managers, said it was important to assess a person’s overall financial situation.

In retirement, liquidity is very important, and one has to determine if investors have sufficient funds outside a retirement vehicle, he stressed.

People who contributed to a retirement annuity or pension fund may only withdraw one-third of the money as a lump sum at retirement. The first R500 000 will be tax free. The remaining two thirds have to be annuitised.

“You need to make sure that you have got enough liquidity on the outside. So it does not benefit me to have all my savings in this retirement fund if I exceed the cap and I don’t have any external money available,” he said.

In terms of Regulation 28 of the Pension Funds Act, retirement funds are not allowed to invest more than 75% of the funds in equities, and 25% offshore.

Discretionary investments don’t need to adhere to the limits set by Regulation 28. Investors who need more offshore exposure would be able to go beyond the limits in a discretionary investment and would also have the benefit of liquidity, he said.

But, if an individual has sufficient liquidity in his portfolio, returns on pension fund contributions are allowed to grow free of tax while inside the fund and as a result the growth would be better than in a normal unit trust structure, Fourie said.

Jenny Gordon, head of retail legal support at Alexander Forbes, said in 2014 a new section 10C was introduced into the Income Tax Act.

“If you make an after-tax contribution to a fund, when you start drawing an annuity you can actually now set off that after-tax contribution against compulsory annuity income so that you actually don’t lose it.”

Gordon said a lot of high-income earners enjoyed using this provision.

“They find that during their [first] couple of years into retirement when their income tax is still quite high, they actually are able to completely write-off from tax the full amount of their compulsory annuity income. So that is one way in which some individuals enjoy contributing over the R350 000 cap to retirement funds,” Gordon said.

Ronald King, head of strategic research and support at PSG Wealth, said there were a number of reasons why he would definitely consider contributing in excess of R350 000 per annum.

The first was for estate planning purposes. In terms of the Income Tax Act (section 7C) an interest-free loan to a trust would be subject to donations tax on a deemed interest of 8%.

In contrast, if someone transferred a R1 million lump sum into a retirement annuity, no tax was payable. Although R1 million would still form part of the investor’s estate, the growth on these funds would not form part of the estate, King said.

“It gives exactly the same estate capping capabilities as the interest-free loan to a trust without any donations tax being payable.”

Moreover, Sanlam data showed that at retirement, a male had a 50% chance of reaching an age of 85. For females, this was 89.

King said there was a good probability that at some point, a person’s finances would be managed by someone else – often his or her children. If these funds are in discretionary portfolios, there is a risk that children could mismanage large amounts of money or spend it.

“You want something that is protected when you can’t protect it yourself anymore and that to me is one of the big reasons why I tell people listen, continue to contribute to a retirement annuity. Get it into the living annuity, so that when your children want to steal your money they have to do it once a month,” he quipped.

King said the fact that there was no tax in the pension fund or retirement annuity itself, also meant that returns for taxpayers in the highest tax bracket are about 2.6% higher than in a discretionary portfolio.

“That means it takes only 15 years for your capital in the retirement fund to exceed the discretionary investment by 45%, which means that if you’ve invested longer than 15 years within a retirement annuity the tax that you pay on your pension is less than the additional growth you got on that portfolio during that period.”

Excess contributions also remain protected from creditors.

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At a Tax Indaba, one accepts the focus will be on tax. But sometimes tax is the opportunity cost you have to pay to get what you want. There are also estate planning pitfalls to the approach to contribute more than the tax deductible contribution. Untimely death pre-retirement from that particular retirement annuity fund (not retirement in general) can lead to unintended loss of control (read section 37C of the Pension Funds Act. This could wreak havoc in re-constituted families. Don’t let the tax tail wag the financial planning dog.

Some interesting justifications and I think it depends how much extra cash the investor has on hand – if they can put extra contributions into an RA and that is just part of their excess cash diversification strategy it might make sense. Personally I would regard Reg 28 plus the limited cash-out capability at retirement as not providing enough diversification from rand-denominated assets. Despite the Rand’s determined strength in the last year or so there has to be a risk of something like 10-30% of a major financial crisis in the next 0-20 years in which SA goes to the IMF for funding or similar. The history of those crises around the world show that capital controls nearly always accompany the huge currency devalautions that happen during these crises. The Fin Rand rulebooks from the 80’s are probably still lying around the SARB. Unless one is highly diversified it may be better to invest offshore in a truly overshore denominated (not local range hedge) while noting the potential pitfalls around estate duty on offshore assets. Pay the extra 2.6% tax quoted on returns and hope that maybe rand devaluation covers it (at 0% CGT inclusion for currency changes) but consider it risk reduction / insurance even if it doesn’t.

One of the statements made at the Tax Indaba is actually earth shattering. King said “…. if these funds are in discretionary portfolios, there is a risk that children could mismanage large amounts of money or spend it” Such kids have no morale fiber, and to think that they would steal from their parents is a horrendous thought.

You have a choice, invest discretionary monies into an RA and have your returns taxed at your marginal rate, or invest them into a unitrust and have only 40% of them ( minus the exclusion) taxed.
In addition it is probable that fees on your RA will be higher than that of a unit trust fund.

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