Tax-Free Account or Retirement Annuity?

If you’re starting on the long journey of creating a nest egg, should you start with a tax free account or a retirement annuity?

They’re not actually mutually exclusive – you can do both – but in this life it’s important to know what you’re buying and why.

Let’s look at the pros and cons.

1. With tax free accounts, you make contributions out of after-tax money. In other words, you don’t get an income tax deduction when you pay into a tax free account.

2. With a retirement annuity (RA), your contributions are “tax deductible” – which means you can subtract your RA contributions from income before tax is calculated.

But wait… there’s more! That makes it sound like RAs are the way to go, right? But there’s a catch…

3. With a retirement annuity, you pay tax on all the money that’s paid to you when you finally use the RA (eg, at age 55). If you take a portion out as a lump sum, it’s taxed. On the part you have to turn it into a pension (it’s compulsory), you pay tax every month on the money you get.

4. With a tax free account, everything is yours, there is no tax to pay when you withdraw money.

To put it simply, with an RA you get a bit of a tax break on your income tax while you’re building the investment… and then pay tax at the end till you die; with a tax free account you invest after-tax money but then it’s yours to do whatever you like with, no strings attached.

Which is better?

Pay Tax Now or Pay Tax Later?

The choice depends partly on your income tax bracket.

If you’re earning a modest salary and paying little or no income tax, an RA has very few benefits.

Your income tax saving on an RA is roughly equivalent to your tax rate. So if you earn R10,000 a month (18% tax bracket) and you contribute R500 a month, your tax saving will be around R90. In other words, the taxman is funding a portion of your retirement savings equivalent to your tax rate.

If you’re a big earner, up at the 39% or 41% tax rate, an RA might be worth looking at (although big salaries usually come with built-in pension plans).

But if you’re starting out and your tax rate is low, you have to ask yourself – is it worth saving a few hundred rand in tax for a product that locks you in until you’re 55 years old and then makes you pay tax on the proceeds until you die?

Be warned, financial advisors will do everything they can to convince you that the RA is the best choice. That’s because they get commission on selling you an RA.

You don’t need a financial advisor to open a TFSA or TFIA. You can do it online and there’s loads of help on the internet if you’re not sure what product to use or which underlying investment to choose. The Franc Academy, for example, has some good tips.

The Bottom Line

TFA or RA? is one of those “it depends” questions.

Whatever anyone tells you, the fact is that you are locked in when you buy an RA and the tax break you get while you’re contributing costs you in tax when you’re withdrawing your money down the line.

With a tax free account you are not locked in – it’s easier to take out money and there’s no tax to pay.

Some people will argue that you need to be “locked in” so that you don’t raid the piggy bank, but if you’re an adult this is a really bad reason to choose a product… just grow up and get some self-discipline.

Contributions to tax free accounts, however, are limited to R36,000 a year (R3,000 a month), so if you’re wanting to save more than this you have to look elsewhere. Personally, I still wouldn’t go for an RA… but that’s another topic!

Whatever you do… do something! Monthly saving / investing is a habit that you need to entrench in your life.