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Using your tax refund to bring home more refunds?

Let’s be honest. It’s seldom with great excitement that we open a message from the taxman. But this time of the year that short note announcing a refund to investors who’ve topped up their retirement annuities in the previous tax year is most welcome. Which brings us to the question: what should you do with your refund?

Most likely some of it needs to go towards childrens’ school fees, your bond or some urgent home repairs, but we hope you also reward yourself for putting away extra money last year by enjoying some of it now. Investing in memories is important, as your older self will need both memorable moments to relive with friends and family – and enough money to retire with dignity.

To make sure you achieve the latter, we recommend that you use at least part of your tax refund for your long-term savings. In most cases a tax-free savings/investment account (TFSA) or retirement annuity (RA) is the tax-efficient choice, as you pay no tax on income or capital growth on your investment while it remains invested.

But which one – TFSA or RA – is a better fit for you?

Do you need the money before age 55?
If you’re one of the fortunate (and diligent) people who can afford to save a substantial chunk of your income every month because you plan to be financially free before the age of 55, then putting more money into an RA may not appeal to you. That is because, under current laws, the earliest date that you may withdraw money from an RA is age 55, and on your retirement date your withdrawal is limited to a lump sum of only one-third of the value of your RA. With the rest of the money you need to buy an annuity income.

If you plan to ‘retire’ early, don’t disregard an RA completely, though. It’s possible to use both a TFSA and an RA as long-term savings products. Once you’ve reached your financial freedom goal you could withdraw the money needed to survive from your TFSA up to age 55, or longer if it lasts, and thereafter ‘convert’ your RA to an annuity income

How much are you looking to invest?
Currently you may invest only R36 000 per tax year in a TFSA. Any additional contributions are taxed at a heavy 40% of the excess above the R36 000 limit. In contrast, there’s no limit on contributions to a retirement product, such as an RA, pension or provident fund. You can invest as much of your income as you please, although only the first 27.5% – capped at R350 000 – is tax-deductible. There’s nothing stopping you from exceeding this limit.

If you contributed more than 27.5% of your total taxable income per tax year or more than the annual R350 000 contribution cap to your RA and employer’s fund combined, there is no reason for concern. You will not be hit with a tax penalty; a tax penalty only applies to excess contributions to a TFSA . With an RA, any excess amounts are simply carried over to following tax years until they are all ‘used up’ for tax deductions. And the returns on them are also tax-free while your money stays in the RA.

Remember, with an RA you pay tax in retirement
A great benefit of both a tax-free investment account and a retirement annuity (RA) is that all the growth and income of the investment are tax-free while you remain invested. This includes tax on interest, dividends and capital growth.

However, an important difference between a TFSA and an RA is that, with a TFSA you pay no tax on withdrawals.

With an RA, only the first R500 000 of your lump sum taken at retirement is tax-free. When you start withdrawing an annuity income, that income is taxable as per the normal income tax tables of the South African Revenue Service (SARS). It’s therefore more accurate to call it a ‘tax-deferred’ investment instead of a tax-free investment. However, for most high-income investors, the income tax rate in active employment is higher than when drawing a retirement income in the future. For example, you might be getting a 41% tax relief now, but your retirement income might only be in the 36% or 31% tax bracket one day when you retire. This makes deferring your tax by contributing to an RA in your higher-earning years worth it. And, on top of that, all the income and growth earned within the RA before you retire is tax-free.

Putting your refund in an RA could reap another refund
If you contributed money to your RA during the previous tax year or made any other tax-deductible payments, such as a donation to a qualifying NGO or qualifying business expenses, you will very likely receive some money back from SARS a few weeks after filing your tax return. If you’ve already used your R36 000 annual TFSA contribution allowance, there’s nothing stopping you from putting your tax refund amount in your personal RA. Even if you’ve maxed out your 27.5% RA allowance for the year, your additional contributions will grow tax free while you remain invested in the RA.

Our TFSA vs RA infographic makes it easy to compare
On this article we’ve highlighted only the main differences between a TFSA and an RA. There are many more differences – relating to the types of funds they may invest in, rules around protection from creditors, estate duty, and parents’ rights on an RA or TFSA held in a minor’s name.

To help you compare these products at a glance, we’ve created an infographic for ease of reference.

Both products have their own benefits and should not be seen as competing with one another, but as complementary components of a holistic financial plan. It’s always a good idea to seek financial advice before deciding how much to allocate to each product.

DOWNLOAD INFOGRAPHIC

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