Newsletter 020812: Retirement savings and tax changes

What a fantastic Olympics in the pool and on the water! We hope you are enjoying the Games.

Today we take a look at retirement planning and what tax considerations need to be taken into account, and how tax changes affect your retirement savings.

Next week is a rather important holiday – Women’s Day – and we won’t be publishing a newsletter. We wish all the Ladies a wonderful day. We will return on 16 August.

We also wish the Sharks, Proteas and all our Olympic athletes the best of luck.

How tax changes affect your retirement planning

In an article published in a financial magazine shortly after the delivery of the annual budget speech, a respected local economist made the comment “…essentially this was not a good budget for the saver…”. But is this really the case? Not necessarily, says John Kinsley, MD of Unit Trusts at Prudential Portfolio Managers. In fact, long term savings via a government-approved retirement vehicle have become even more attractive than before. Investors should be informed of the long term impact of tax changes on different investment vehicles to ensure they have adequate savings.

The most important tax changes for future retirees relate to capital gains and dividends

The two tax changes that are particularly relevant are:

1. An increase in Capital Gains Tax for the individual from 10% to 13.3%.

2. The introduction of a Dividend Withholding Tax of 15% on all dividends paid to South African individuals.

Investing in a government-approved retirement fund versus a balanced unit trust has different pros and cons

To really see how these changes affect your retirement planning, we will use a case study of a 35-year old individual who wishes to retire at the age of 60 and can afford to set aside R2 500 each month towards retirement. Also, whereas most analysis focus only on the build-up phase (before retirement), we will also take into account the actual retirement phase.

The table below summarises the differences between investing in a retirement annuity versus investing in a balanced unit trust as an individual:

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The tax changes have different implications for the returns on different savings mechanisms

To illustrate the impact of the tax changes on the returns of these two savings options, we’ll assume the targeted return for both options is inflation plus 5% after investment management fees of 1% per year, and that inflation is 6%.

The two tax changes mean the following in our practical example:

1. For the individual investor (option 2) dividends will be taxed at 15%, while in a RA (option 1) there is no tax on dividends.

2. For the individual investor (option 2), any interest above the exemption level will be taxed as income – we assume an average rate of 35% – while in an RA there is no tax on interest.

This difference in tax means that the effective return for the RA (option 1) is 11% per year, while for option 2, it drops to 10.5% per year.

A seemingly small impact on returns can make a significant difference in the long run

“Even though 0.5% might not seem like a big difference, the compounding of this differential over many years will have a big impact on how much savings you, and your dependants, have at and during retirement,” explains Kinsley.

Focusing on the first two phases of the retirement cycle, the figures in the tables and the chart below show exactly to what extent the different tax treatments of options 1 and 2 impact returns over the long term.

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In the third phase where the surviving spouse continues to draw the same income based on the same assumptions for another ten years, the difference between the final portfolio values of the two options becomes even more marked.

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Investors should decide what their priorities are when it comes to retirement savings and make an informed decision

Investors have different circumstances and views, and some may regard having more control over their money, as in the case of investing in a balanced unit trust, as essential. The final decision will always remain a personal one, but the numbers certainly do tell a story that is worth considering.

The comment and opinion in this newsletter is comment and opinion only and does not in any way constitute financial advice. Please consult a professional planner for all financial and investment decisions.

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