The day you reach retirement

Retirement planning often involves finding a balance between maintaining a comfortable lifestyle now and securing financial stability when you retire. But life is unpredictable and unexpected expenses can arise. To maintain your desired standard of living, it is crucial to also have discretionary savings.

Making provision for both planned and unplanned discretionary expenses throughout your lifetime is key to balancing your savings. Discretionary savings give you flexibility and liquidity and should (1) provide for unexpected expenses by way of an ‘emergency fund’ that can be accessed immediately and (2), importantly, provide for income in retirement, so you do not end up with all your savings tied up in a compulsory annuity.

When you retire, at least two-thirds of your retirement fund savings are used to buy a compulsory annuity (pension). The balance becomes part of your existing (discretionary) savings pool.

Discretionary savings - main benefits

• Flexibility: allow retirees to access funds as needed without restrictions, offering the freedom to withdraw or invest according to personal circumstances.
• Tax efficiency: while contributions to discretionary savings are made from after-tax income, the investment growth may be tax-effective, especially if managed through tax-efficient vehicles.
• Supplementary income: an additional income stream, complementing your retirement investments.
• No contribution limits: unlike retirement plans, there are no limits on how much one can contribute to discretionary savings plans.
• Peace of mind: knowing that you have a financial safety net reduces stress and provides peace of mind. Before and in retirement… be precise It is very important to distinguish between before and in retirement when referring to benefits. For example, despite their flexibility, discretionary investments lack the before retirement tax benefits associated with retirement funds. There is no tax payable on interest, dividends or capital gains while invested in a retirement plan. In addition, discretionary investments do not offer protection from creditors, unlike retirement funds. This can be a concern for those in financial difficulty – typically before retirement. Lastly, investors need to be aware of the ‘risks of having access’ to capital in their discretionary savings pool before retirement if it is earmarked to supplement your income in retirement. As an investor you need to be disciplined enough to not access this capital prior to retirement.

The income, capital and growth conundrum

Compulsory savings

Retirement funds are tax-deferred, meaning that you do not pay tax within the retirement wrapper while your member share grows, but you are taxed when you start drawing an income. If, for example, you are drawing from a living annuity, the income is taxed as ordinary income according to the personal income tax tables. Currently, this ranges from 18% to 45%, depending on the amount of income drawn.

The administrator of the living annuity will deduct the tax upfront and pay it to SARS, depositing the net income amount into your account. Given the tax treatment, drawing large amounts solely from your retirement annuity could push you into a higher tax bracket, as 100% of the income drawn is taxable.

Discretionary savings

On the other hand, income from discretionary investments consists of a capital portion and a growth portion, meaning it is only taxed on a portion of the amount withdrawn, as opposed to income from retirement funds, which is 100% taxable. Discretionary savings – which includes collective investment schemes (‘unit trusts’), share portfolios, endowments and money market investments – are all taxed differently. These investments are not subject to the same regulations, allowing you to tailor your investments to your preferences.

• Capital gains tax (CGT): only realised capital gains are subject to CGT, and the first R40 000 worth of gains each year is exempt. Beyond that, 40% of your capital gain is included in your taxable income, and you are taxed at your marginal rate.
• Dividends withholding tax: if you receive dividends from shares, these are subject to a 20% withholding tax.
• Endowments: tax is payable on all interest and capital gains, but at a standard rate of 30% rather than your marginal tax rate. Dividends are taxed at 20%.
• Interest income: interest is taxed at your marginal tax rate but the first R23 800 (for individuals under 65) and R34 500 (for individuals over 65) of interest is tax-free.

Finding the optimal combination

It is essential for investors to consider the different tax treatment of retirement funds and discretionary savings. How you use the two savings pools depends on several factors, including withdrawal rates, income needs and liquidity requirements. Ultimately, the best strategy often involves a combination of both savings pools, allowing you to optimise tax efficiency while maintaining liquidity for unforeseen needs. By understanding the trade-offs and aligning your investments with your financial goals, you can create a strategy that supports both your immediate and long-term financial well-being.

There are several strategies that can save you taxes in retirement and increase your disposable income, that follow below.

1. High income earners - disallowed contributions

The reality is that this strategy will not benefit the average salaried employee since their existing contributions will more than likely fall comfortably within the 27.5% deduction and the R350 000 cap. However, higher income earners have the option to invest more than R350 000 in a retirement plan. The decision to invest more than R350 000 is not a simple decision as there is no right or wrong answer.

If you opt to do this, Section 10C of the Income Tax Act provides that any previously disallowed contributions that have not been set off against your lump sum taken at retirement, may then be applied towards exempting annuity income received from compulsory annuities. This in effect, reduces your income tax payable until all disallowed contributions have been used up.

If you think about it slightly differently, when you retire your disallowed contributions allow you to convert a larger amount into discretionary savings, exactly what you want considering the annuity tax dilemma you have in retirement.

2. Split your income with your spouse

Splitting your income with your spouse can effectively reduce your overall tax liability. Remember a donation made to a spouse is completely exempt from donations tax. By sharing income, you can take advantage of lower tax brackets and exemptions for both individuals. This strategy is particularly beneficial if one spouse is in a higher tax bracket than the other.

3. Plain discretionary savings vehicles

There are various ways to invest – from bank fixed deposits to CISs, model portfolios, exchange traded funds (ETFs) and share portfolios. The appropriate allocation of discretionary investments depends on factors including your individual circumstances, your tolerance for risk and whether you specify financial goals such as saving to supplement the pension you will receive from your compulsory annuity in retirement.

4. Start early – TFSA

Build up your tax-free savings (TFSA) long before retirement. Tax free savings remain an extremely useful planning mechanism and by starting your tax-free savings long before retirement, you can build up meaningful capital that can be used in retirement to provide tax free income.

Also maximise this benefit between yourself and your spouse or partner to ensure that you get a decent return on this. It is of little use investing in a tax-free savings account in cash or interest-bearing assets (in your bank) as this does not allow your money to grow over time to create meaningful wealth in retirement.

In starting contributions to tax free savings 14 to 15 years before retirement – it takes roughly 14.5 years to reach the R500 000 lifetime limit – you can accumulate a meaningful amount to provide additional capital, used as tax free income in retirement. However, as there are limits on how much you can save in these vehicles and you cannot replace what you withdraw, it is generally advisable to access other savings and investments first before tapping into your TFSA.

Examples

To demonstrate the actual impact of tax, we show examples of the strategies above. The tax impact will vary based on personal circumstances, e.g. level of income, RA contributions, amount and timing of plain savings, type of pension, dividend yield and timing of realising capital gains.

Conclusion

Discretionary income is a powerful tool for shaping your financial future. By understanding the pros and cons of various discretionary investment vehicles and how they can be used to supplement your annuity in retirement, allows you to make informed decisions that lead to greater financial freedom.

The help of an experienced and qualified financial adviser can be invaluable to help you invest your discretionary savings appropriately.