One tax mistake costs South African retirees R213,000 every year

South African retirees can end up paying hundreds of thousands of rand more in tax each year simply by drawing their retirement income from the wrong source.

This is according to Galileo Capital CFP Frank Daubenton, who said the order in which retirees access their savings can have a major impact on their annual tax bill.

Daubenton explained that many retirees spend years building up their savings but lack a clear plan for how to use them once they stop working.

Galileo Capital recommends that retirees use a four-layer approach to generate income while keeping taxable income as low as reasonably possible.

This approach comprises an emergency fund, annuity income, discretionary investments, and a tax-free savings account (TFSA).

Daubenton said the foundation of a retirement income plan should be an emergency fund covering six months of living expenses.

For someone spending R20,000 a month, this would mean keeping R120,000 in an accessible account or money market fund.

The money is intended for unexpected expenses such as medical bills, home repairs, or family emergencies, rather than regular monthly spending.

There can also be a tax benefit for older retirees. For people aged 65 and above, the first R34,500 of interest earned each year is exempt from tax.

A R120,000 emergency fund earning 8% would generate R9,600 in annual interest, keeping it below the exemption.

Once the emergency fund is in place, Daubenton said the annuity should generally provide the main source of regular monthly income.

Living annuity withdrawals are taxed as ordinary income, meaning the amount withdrawn has a direct impact on a retiree’s taxable income. Living annuity investors can draw between 2.5% and 17.5% of the fund value annually.

Daubenton noted that drawing at the lower end can help preserve capital, while higher withdrawals can accelerate the depletion of the fund and increase tax exposure.

For example, if a 65-year-old retiree keeps total annual taxable income below R148,217, the combined age rebates can result in no income tax being payable.

Discretionary investments and tax-free savings

When an annuity does not provide enough income, Daubenton said retirees should consider their discretionary investments before increasing their annuity withdrawals.

These assets can include unit trusts, shares, endowment policies and other investments held outside retirement funds.

The tax treatment depends on the underlying investment. Interest may be partly exempt. Dividends are subject to dividends tax, and capital gains tax can apply when assets are sold.

Other income, such as rental income, consulting work, or income from a family business, must also be included when determining the retiree’s overall tax position.

Daubenton said the exact order depends on the individual’s circumstances, but retirees should consider their entire tax position before increasing withdrawals from a single source.

Galileo Capital also recommends that retirees invest in a tax-free savings account. However, this should remain untouched for as long as possible.

This is because interest, capital growth, and dividends generated inside a TFSA are not taxed.

Using the account for regular retirement income means giving up future tax-free compounding that cannot be recovered.

For this reason, Daubenton said a TFSA should be viewed as the final “layer” of a retirement income plan.

It should be preserved for a significant once-off expense or left to grow while other assets cover regular living costs.

Retirees can lose hundreds of thousands

Not having a tax-efficient strategy can mean that retirees lose hundreds of thousands of rands every year, Daubenton explained.

To illustrate this, he used an example of a 68-year-old retiree whose assets total R21 million.

Their assets include an R8 million living annuity, a R9.8 million discretionary investment portfolio, a R500,000 tax-free savings account, a R400,000 money market emergency fund and a primary residence.

This person needs R800,000 a year after tax, or R66,700 a month, and is drawing the entire amount from their living annuity. This means they have to withdraw R1.13 million from the annuity.

As a result, they would pay R326,000 in tax while withdrawing an annual annuity rate of more than 14%.

According to Daubenton, a better way to structure this would be to split their income between the annuity and discretionary investments.

For example, the annuity withdrawal can be reduced to 5%, or R400,000 a year, while R513,000 is drawn from the discretionary portfolio. This will give a combined gross income of R913,000.

This would result in them paying R51,000 in tax on the annuity income after rebates and their medical aid tax credit.

The discretionary withdrawal has a different tax treatment because it consists of a combination of capital returns, dividends, and investment growth. The effective tax on this is R513,000 at around 12%, or R62,000.

Restructuring their income in this way would change the retiree’s total tax bill to R113,000. This means they would have the same R800,000 after-tax income but pay R213,000 less in tax every year.

The annuity withdrawal rate also drops from more than 14% to 5%, which reduces the pressure on the underlying retirement capital. Their TFSA also remained untouched and continues to compound without tax.