Two ways to pay less tax in South Africa

South Africans can easily reduce their annual tax bill by contributing towards a Retirement Annuity (RA) or investing through a tax-free investment account. 

However, fewer South Africans are reaping the benefits of these accounts as they withdraw funds early from their retirement accounts under the new two-pot system. 

Many use tax-free investment or savings accounts as emergency savings accounts, regularly withdrawing from them to make immediate payments. This means they miss out on the benefits of tax-free compounding. 

This is feedback from the head of Allan Gray’s tax team, Carla Roussow, and senior manager, Lee Kotze, who outlined the tax benefits of investing in such accounts. 

The best way to reduce your tax bill every year is to consistently contribute to your retirement, as the amount invested is tax deductible. 

Every year, you can make a pre-tax contribution to your retirement fund of up to 27.5% of your taxable income, capped at R350,000 per tax year. You forfeit this benefit if you do not make use of it.

For instance, if you fall into the 45% tax bracket and contribute R100,000 to your RA, your actual cost is only R55,000, as SARS covers the remaining amount.

While withdrawals at retirement are subject to tax, the overall tax burden is typically lower due to tax-free portions of the lump sum and additional rebates for individuals aged 65 and older.

The other annual tax benefit the government offers is the ability to invest R36,000 per tax year and up to a maximum contribution of R500,000 over your lifetime of after-tax money in a tax-free investment account. 

Both retirement funds and TFIs benefit from growth free of any tax, including dividends tax, income tax on interest, and capital gains tax, while you are invested.

This can yield significant benefits over the long term as the effect of compound interest will be magnified.

South Africans missing out

Many South Africans are missing out on these tax benefits as they withdraw prematurely from their retirement funds or use tax-free accounts incorrectly. 

Roussow explained that while individuals are able to access funds in the savings component of their retirement fund, it does not mean that they should. Withdrawing should not be viewed as an annual event that must happen.

Crucially, withdrawing prematurely has significant tax implications as these funds will be taxed at an individual’s marginal rate. 

The tax due on your withdrawal will be withheld and paid over to the South African Revenue Service (SARS) and you will receive the after-tax amount. 

Any outstanding taxes that you owe SARS may also be deducted from your withdrawal prior to the benefit being paid to you.

These early withdrawals will also negatively impact your financial outcomes in retirement as the amount invested and able to compound will be reduced. 

Tax-free accounts are slightly different in that there are no limitations on withdrawals and these funds are not taxed, making it tax-efficient to withdraw money from these accounts. 

However, there will be negative consequences further down the line as withdrawals cannot be replaced as contributions are limited to R500,000. The amount contributed is not reduced by the withdrawals made. 

Furthermore, as with early withdrawals from a retirement account, the financial outcome at maturity will be negatively impacted as compound interest will not be able to work its magic. 

Old Mutual recently warned that this is becoming a much larger problem for South Africans as an increasing number are using these tax-advantaged accounts for their emergency savings. 

Traditional financial advice recommends maintaining three months’ worth of expenses in an emergency fund. However, inflation erodes the value of cash, making it challenging to keep pace with rising costs. 

Old Mutual advice manager Keith Peter explained that This pressure has pushed some South Africans to consider placing their savings in other investment products.

Implementing the new two-pot retirement system has exacerbated this as its flexibility has made it useful for people looking to park their emergency savings elsewhere. 

Peter warned that this strategy is risky and encouraged South Africans to think carefully before using market-linked retirement funds for this purpose. 

These funds are not designed for short-term savings. They are intended to generate strong returns over the long term, not to provide short-term immediate volatility.