“Discipline is choosing between what you want now, and what you want most,” Abraham Lincoln, the 16th president of the US famously said.
From the perspective of a young investor, one might ask: “Are you spending your money on ‘things’ or are you ‘paying yourself first?’”
Psychologists tells us that younger people find it difficult to visualise themselves as 65-year-olds, and won’t easily make trade-offs where they sacrifice enjoyment now so they will have capital later in life. Yet they should – and one of the best ways to make a small sacrifice now for a big benefit later is to use a ‘free deal’ from the taxman.
It involves contributing to a retirement fund, and re-investing the tax saving you get back from the South African Revenue Service (Sars) in a retirement annuity.
One of the main criticisms of retirement annuities (RAs) is that you will eventually have to pay tax on the money saved in the RA. If you invest more than R1 000 a month into an RA now and increase the contributions yearly with inflation for 35 years, this will probably be the case.
When you invest in an RA, you are deferring tax (which is really a good thing), but it doesn’t necessarily mean you are never going to pay tax. The benefit of deferring tax is that you give your capital more time to grow so that the tax is effectively paid by capital growth.
Investing the tax saving on your retirement fund contributions in an RA is one option, but you could also consider a combined plan where you invest in a tax-free savings investment or a flexible investment.
If you were to invest the tax saving from Sars into an investment vehicle such as a tax-free savings investment, it allows you to build up an amount which you will be able to access as additional tax-free income when you are older.
By structuring your investments optimally over a 35-year period (if Sars increases all the yearly deductions that individuals receive with inflation), you should be able to receive a monthly income of R25 311 in today’s purchasing-power terms that is tax-free.
Let’s consider two scenarios – one where you don’t re-invest the tax saving, and one where you do.
In both instances, you start by putting R4 500 a month into a retirement annuity, and in both instances you want to draw the equivalent of R20 000 a month in today’s terms from age 65 onwards (increasing each year in line with inflation).
With the second scenario, we deduct 5% per month (effective tax rate on non-retirement income; for assumed interest tax and possible capital gains tax) but – importantly – save an additional amount each month by re-investing the tax saving from Sars into a flexible investment. To keep things simple, I have not increased the living expenses by the amount not saved per year in the first scenario.
Annual income projection from age 65, available versus required
Where you don’t re-invest the tax saving from Sars on your retirement fund contributions – by age 84, the income required will exceed the amount the investments will be able to provide:
Where you do re-invest the tax saving from Sars on your retirement fund contributions – taking our assumptions into account, the income provided should last to age 99:
Graphs done on the Elite Wealth System
The difference that effective and tax-efficient saving can make to your life is astounding. You can effectively increase the life of your money by 15 years. All it takes is some discipline.
* Christiaan Bekker is a certified financial planner at Verso Wealth.
Source: Money Web