Despite the tax benefits on retirement contributions and the tax free growth, the fact that pension income benefits are ultimately taxed has led people to question whether saving in a retirement fund really is better than making your own retirement savings arrangements with after-tax earnings.
One of the main ways government encourages people to save for retirement is to offer tax deductions on saving in an approved retirement fund. While this tax relief can be very helpful when you’re working and contributing to a retirement savings fund, the benefits that you eventually receive from your retirement fund when you stop working are still taxed.
To help South Africans make informed retirement saving decisions, we conducted a thorough investigation into how tax impacts retirement outcomes. The analysis aimed to compare the tax impact of various vehicles to save for retirement.
The three vehicles considered were:
- Retirement fund
- Discretionary savings, i.e. using after tax income
- Tax Free Savings Account (TFSA)
Five different scenarios (using different combinations of these three vehicles) were compared:
- Scenario 1: Discretionary savings only (Discretionary)
- Scenario 2: Discretionary savings, but including saving in a Tax Free Savings Account (Discretionary TFSA)
- Scenario 3: Saving in an approved retirement vehicle (Retirement)
- Scenario 4: Saving in an approved retirement vehicle and also reinvesting any tax savings on a discretionary basis (Retirement Plus)
- Scenario 5: Saving in an approved retirement vehicle, and reinvesting any tax savings in a Tax Free Savings Account as well as in a fully taxed, discretionary vehicle (Retirement Plus TFSA)
The analysis also considered different levels of income, because the impact of tax depends on how much you earn. People who earn higher salaries pay more tax, which means the different tax treatment of the savings vehicles result in more significant impacts for higher income earners.
Three levels of pre-tax income were compared:
- R20,000 per month
- R60,000 per month
- R120,000 per month
In all five scenarios, and across all three income levels, the full impact of tax (both before and after retirement) was modelled to compare the impact over the lifetime of an individual. This required some important assumptions, including that the tax regime would remain the same as now, adjusting limits and caps by inflation where appropriate.
The analysis provided some valuable insights.
Scenario 3 – best outcome in terms of income after tax
As expected, it emphatically shows that the Retirement scenario (scenario 3) provides the best outcome in terms of income after tax, both before and during retirement. The difference is significant. Based on the same level of take-home pay before retirement, the Retirement scenario provides an after-tax pension that is just over double the income under the Discretionary scenario (scenario 1).
Scenario 1 – worst outcome across all income levels
By contrast, the Discretionary scenario provides the worst retirement outcome across all three income levels. This is because the additional tax being paid on your salary, due to not benefiting from retirement contribution tax deductions, leaves relatively little money over to make a substantial post-tax contribution to discretionary retirement savings and the difference was more evident at higher income levels.
Although the Retirement Plus scenario (scenario 4) also produces a much better outcome than the Discretionary scenario, it still did not quite match up to the pure Retirement scenario. For a person earning a R60,000 per month gross salary, it provides an after-tax pension that is 75% higher than under the Discretionary scenario, compared to an extra 102% in the Retirement scenario.
Introducing a Tax Free Savings Account does improve the outcomes of both the Discretionary TFSA (scenario 2) and the Retirement Plus TFSA (scenario 5), but they still fall short of the Retirement scenario (scenario 3). This is because the Tax Free Savings Accounts only provide tax relief on growth and there are limits on contributions, so the benefit is limited.
Interestingly, across all income levels, the Retirement scenario produces a net replacement ratio (that is the ratio of income after tax in the year after retirement date, to the salary after tax just before retirement) of about 100%. This is based on savings of 15% of salary and a 40-year working career lasting for 25 years in retirement. This demonstrates that a suitable and diligent long-term savings plan can deliver a sound retirement outcome.
When evaluating these options, however there are a number of factors that need to be considered – only one of which is the impact of tax.
That said, taxation is an important factor and it is useful to look at the full impact the various savings approaches could have on your current take-home pay as well as on your retirement benefit one day.