The Retirement Annuity Tax Snowball
As the financial year comes to a close, February for me is all about two acronyms RA and TFSA.
For those not in South Africa, a TFSA is a Tax free Savings Account (in the UK, they're called an ISA and in the US an IRA) and an RA is a Retirement Annuity (in the UK, they would be called a Pension and in the US a 401k).
In SA, you can invest R36,000 / $2,400 / £1,850 per year in a TFSA and R350,000 / $23,000 / £18,000 or 27.5% of your taxable income (whichever is the lesser) to an RA.
And that is about as complicated as it gets, in the TFSA, all of your growth, dividends and interest is not subject to capital gains, dividend tax or income tax so you get 100% of the growth when you finally cash it in.
TFSAs are a no brainer, they should be the first investment you buy and the last you sell, if only to stick two fingers up at the government in a Johnny Rotten anarchistic style. They're a relatively hands off investment although you can hold funds and ETFs in a TFSA so you can move them around if you want to. any money you take out can't be put back in, hence why they should be the last investment you sell.
TFSAs are the kings of compound interest. As Jack Bogle the founder of Vanguard once said about passive index investing .
"Make the investment and don't even look at how it's doing until you're ready to retire, don't even look at your annual statements. when you finally decided to cash it in, open the statement and make sure you have a doctor on hand for when you see how much money you've made"
I'm paraphrasing but it's an important point, if you find a good cheap solid passive investment, stick it in a TFSA and leave it for 30 years, the annual returns your getting by then will outweigh the total investment by a long chalk. That no tax gain, adds up and you get tt withdraw it all with no fees to pay. It's a gift from the government and we don't get many of those!
However, R36,000 / $2,400 / £1,850 a year is probably not going to keep you in the lap of luxury in retirement so you're going to need an RA as well. Most people know that you can claim tax relief on RA contributions but not many truly appreciate the power of snowballing those returns.
What is snowballing of returns? It couldn't be more simple, it's just reinvesting your returns which is what all RAs do automatically, mostly because you're not allowed to withdraw from them until you're over 55.
However, there is another snowball available with RAs and that is the tax snowball.
Allow me to explain. When you pay into an RA, at the end of the year, you get to claim back to the tax you invested in it at your income tax rate. For the purposes of this explanation, I'm going to use 45% as that is the income tax rate I paid during my working years in South Africa. Let's also say I earn R1,500,000 $100,000 £75,000 per year for simplicity (and that is the 45% tax bracket for last year), this means I can pay up to R350,000 / $23,300 / £17,500 per year into an RA. Again for the purposes of this example, we're going to save the full allowance as that is what anyone pursuing a FIRE lifestyle should be doing without fail. All good so far? Remember those numbers.
OK lets math the shit out of this:
Year 1 - We contribute the full R350,000 / $23,300 / £17,500
Year 2, we claim our tax relief on year 1 of R157,500 / $10,500 / £78,75 and reinvest it, we make up the different to get the total contribution to be R350,000 / $23,300 / £17,500
We repeat this process for 5 years, paying in the full amount, claiming the tax relief and reinvesting it.
What most people don't join the dots on is the snowball reaction of this. Let me show you:
In year 1, our RA is worth R350,000 / $23,300 / £17,500 and we paid in R350,000 / $23,300 / £17,500, that's 100% contributions by us.
In year 2 our RA is worth R700,000 / $46,66 / £35,000 but we only contributed R542,500 / $36,166 / £27,125, That means we now only contributed 78% of the value from our hard earned.
In year 3, our RA is worth R1,050,000 / $70,000 / £52,500 but we only contributed R735,000 / $49,000 / £36,750 which is just 70%
I'll skip year 4 because you're a clever lot but the important bit is that by year 5, your contributions only represent 64% of the total value. And that's before we even get onto growth.
If you don't reinvest your rebate, you stay at 100%.
In case you're not yet seeing it, what is happening here is you are able to claim tax relief on your tax relief, over and over again. Nowhere else in the tax regime is this double counting allowed or tolerated, in fact in most areas you'd go to jail!
Now let's add in growth and look at the picture again, would you like to get a return on your tax relief you've claimed over and over again? don't answer that, I know you would.
So lets make it simple again and assume a 10% return on our RA, this might be a bit punchy for most institutional RA's but if you're smart and have an RA that lets you choose your own investments (like Sygnias RA) 10% over the long term is not out of the realms of possibility.
Now let's jump straight to year 5, first without considering the tax impact :
Total Value of RA: R2,350,463 / $156,697 / £117,523
Total Contributions including tax rebates: R1,750,000 / $116,666 / £87,500
Total profit from investment growth: R600,463 / $40,030 / £30,023
Contributions as a percentage of total value: 74%
Ok, so pretty standard, 34% return over 5 years, not bad.
Now let's look at the same numbers with the tax rebate snowball:
Total Value of RA: R2,350,463 / $156,697 / £117,523
Total Contributions excluding tax rebates: R1,120,000 / $74,666 / £56,000
Total profit : R1,230,463 / $82,030 / £61,523
Contributions as a percentage of total value: 48%
Boom! there it is, the government has doubled your return.
Now you could argue that what I haven't factored in here that in the first scenario, you got to spend your tax rebate, and that is true, but if that is your first thought, you're missing the point compadre.
The point here is that the RA is THE BEST way to pay less tax while you're saving for retirement but it is capped to keep you working until you're 55. By reinvesting your rebate and constantly maxing out your allowance, you're stacking serious bank for when you get to 55. And the sooner you take care of life after 55, you can start shortening the gap between your current age and 55 and that means you get to retire earlier.
Another element to this and a less understood hack is that you are actually allowed to pay in more than the RA allowance. However, you are not allowed to claim the tax back after the limit.
So why would you do it? Let me give you a quick perspective.
I invest in the same things through my RA that I do outside my RA, so the returns are the same. The only difference is I get tax relief on my RA contributions up to the R350,000 / $23,300 / £17,500. Which I reinvest of course.
But what if I just pay the R350,000 / $23,300 / £17,500 in out of my cash and then when I get the rebate, throw that in their too? that would mean I would be putting R507,500 / $33,833 / £25375 but only paying R350,000 / $23,300 / £17,500 every year. But I can only claim a tax rebate on the R350,000 / $23,300 / £17,500 so why would I do that?
Well let's assume for a minute I can afford to do that and I have enough post tax cash to lock that extra money away until 55. In this instance what I'm doing is pre-paying my tax for later down the line. yes, you can carry over the additional tax rebate to later years, and it never expires, never!
So lets say I do that for the next 10 years and then cash in my RA at 55. By that time I've paid in an additional R1,575,000 / $105,000 / £78,750 that I've never had any tax relief on.
I can then offset that against the income from my RA to reduce my tax liability during my late retirement and guess what? I can still contribute into an RA so between those two, I have a pretty good control over my tax bill and can control absolutely legally how much to contribute versus how much to drawdown from my RA to keep me in a lower tax bracket.
My head hurts now but I hope you see where the magic is here and why it's so important in a FIRE lifestyle to save into your tax efficient savings first, even if they may not be as exciting as your other investments.
If this didn't make sense, and let's face it, it's a bit of a rabbit hole. If you're a high rate tax payer, all you need to know is that your RA will provide you with the equivalent of a 45% return every year with no risk. Show me where I can get that anywhere else?
Let me end on the usual caveat, I'm not a tax practitioner and this is not advice, it is based on my own research and findings but no two tax situations are the same so you should always talk to someone much more clever than me before making any investments that affect your tax position.
With that said, I'd love to hear your views in the comments, as always this is a highly debatable subject but also a cornerstone of the FIRE lifestyle so if you think I'm full of it,. let me know!
Until next time, Keep Living.