In the process of wealth creation, the impact of taxation remains the main detractor. So, when an investor has the opportunity to invest in a tax-efficient or incentive way, it is always advisable to take advantage of these advantages to their advantage. As most South African investors know, the most common investment tax advantage is the tax deductibility of contributions made to approved pension funds.
Approved pension funds include professional funds offered as a result of professional activity, which are provident and retirement funds, and retirement annuity funds taken out on an individual basis. Simply put, contributions made to any of these funds are tax deductible up to a maximum of 27.5% of taxable income, up to a maximum of R350,000 per year.
While many South African investors are using pension funds to build wealth for their retirement years, many are not taking the opportunity to structure their contributions in a pre-tax manner – which can inadvertently affect the growth of their investments. Don’t forget that mandatory contributions to a company pension or provident fund are made before tax, contributions to a retirement pension are generally made after tax. In other words, private RA investors generally make their RA contributions out of their after-tax net income and, although these contributions are always tax deductible, it is important to keep in mind that the investor does not will actually reap the benefits of the tax deductions the following tax year, ie when the investor receives his tax refund from Sars. In such circumstances, the investor will generally use the refund to make an ad hoc lump sum contribution to their RA to obtain other tax deductions in the current tax year.
Take the example of Noxi, who currently invests an amount of R5,000 per month for his retirement pension on an after-tax basis.
|Table 1: After-tax savings scenario|
|Gross income (per month)||R40,000|
|Less: Income tax||-R8 053|
|Net revenue||R31 947|
|Less: RA monthly contribution||-R5,000|
|Net cash||R26 947|
In the example above, it is clear that over the tax year, Noxi would contribute a total of R60,000 (i.e. R5,000 x 12) to her post-tax retirement pension. Being tax deductible, Noxie can expect to receive a tax refund of approximately R18,600 in the following tax year. If Noxie chooses to invest her refund in her RA as a lump sum, her total contribution would be R78,600.
The downside to this approach is that Noxi’s total contribution of R78,600 is made over two different tax years. This is because her monthly contributions totaling R60,000 are paid in the initial tax year, while the remaining R18,600 are invested in the following tax year once she receives her reimbursement of Sars. The delay in investing her Sars refund has a direct impact on the potential capitalization that her investment would benefit from if she invested the full R78,600 in the initial tax year.
For Noxi to take fuller advantage of the power of compounding, it would make more sense for her to invest in her AR on a pre-tax basis. By doing so, Noxi will benefit from tax deductions on a monthly basis which, in turn, will allow her to increase the net annual contribution to her RA, assuming she is happy to withdraw the same net amount in cash at the end of each month. (according to the after-tax savings scenario in the table above).
Noxi can now increase her monthly contributions to her RA in order to benefit from a pre-tax deduction while maintaining the same net cash position at the end of each month. As she increases her pre-tax RA contribution, Noxi’s taxable income will be reduced according to the table below:
|Table 2: Pre-tax savings scenario|
|RA pre-tax deduction||-R7 250|
|Adjusted gross taxable Income||R32,750|
As can be seen from the above, by increasing her monthly pension fund contribution to R7,250 and using a pre-tax deduction, Noxi reduced her monthly taxable income to R32,750, although she still earns gross income of R40,000 and earns a net income. income of R26,945 per month, as per the table below.
|Less: Tax on adjusted taxable Income||-R5 805|
|Net revenue||R34 195|
|Less: RA monthly contribution||-R7 250|
As shown in the table above, Noxi is in the same net effective position, although her annual contributions to her retirement pension have increased to R87,000, while in the after-tax scenario in Table 1 above, Noxi’s total pension fund contributions were R78. 600. This results in a 10.69% increase in contributions simply by rearranging how and when the tax deduction is applied. In addition to the above, all contributions made in the pre-tax scenario are made in the initial tax year and are not spread over two years, which means that these contributions are exposed to the markets between 12 and 18 months longer than in the post-tax year. tax saving scenario.
Although the numbers used in the examples above may seem nominal, keep in mind that when applied the following year, the increased contributions on top of the additional funding period can have a dramatic effect on growth. term of Noxi’s investments. Additionally, as Noxi moves to a higher tax bracket, the effect of savings on a pre-tax basis will be even greater. The example above reminds us that strategic tax planning is an integral part of the financial planning and wealth creation process.