Pension plain: Are non-deductible retirement contributions worth it?

By: Brett Ladouce

In this article, I am revisiting my article, “Does it pay to make the maximum tax-deductible contribution?”, published in Personal Finance on June 5, 2023. In that article, I highlighted the benefits, from a tax perspective, of making the maximum allowable tax-deductible contribution to your retirement fund, namely, 27.5% of your taxable income (limited to R350 000 per year). I still challenge anybody to disprove my opinion that making the maximum tax-deductible contribution to a retirement fund will exponentially improve your retirement outcomes.

In the last few weeks I have read a few articles that expressed the view that there are tax benefits in making additional contributions to your retirement fund over and above the contributions that qualify for an immediate tax deduction. The crux of the argument seems to be that whatever additional non-tax-deductible contributions you put into your fund today will be returned to you “tax-free” as part of your lump sum retirement benefit or as a “tax-free” monthly annuity. In addition, between now and your date of retirement that additional contribution will earn tax-free investment returns in the retirement fund. The fact that the tax-free income earned on the additional contributions will be taxed when you take it out of the fund as a lump sum retirement benefit or as an annuity is often not highlighted. Neither is the fact that when the after-tax capital that you invest or contribute to an investment vehicle is returned to you when the investment matures, it will not attract income tax as it does not form part of the investment income that is taxable.

It remains my view that we should all save as much money as possible for retirement and that a retirement fund is the most tax-effective retirement savings vehicle due to the (limited) up-front tax deduction on fund contributions, the tax-free accumulation of investment return during fund membership, a lump sum retirement benefit tax rate that might be lower than your marginal tax rate and protection of your retirement savings against your creditors. We should thus not limit our saving for retirement to the tax-deductible amount if we can afford to save more for retirement. It is however not clear if a retirement fund is the most tax-effective vehicle to invest the extra money that you want to save towards retirement.

Example: Mr. X earns R1 000 000 per year and contributes R275 000 (27.5% of his taxable income) per year to his retirement fund. He wins R2 000 000 in the Lotto and decides to save R1 000 000 of that amount for his retirement in 10 years from now. He has the following options (which all earn interest or investment growth of 10% per year):

1. Contribute the R1 000 000 to his retirement fund in addition to the R275 000 annual contributions without receiving a tax deduction on that additional R1 000 000 during the 10-year period.

2. Invest the R1 000 000 in a Government Retail Bond that earns interest income over the 10-year period.

3. Invest the R1 000 000 in an equity-based unit trust.

If the annual interest income exemptions, capital gains exemptions, income tax and capital gains tax are considered, the retirement fund and unit trust investment will each produce R1 593 742 in investment growth while the retail government bond will only produce R1 420 572 in interest income over the 10-year period. The difference in gross investment income earned is because the income from the retirement fund and unit trust investment are only taxed at the end of the 10-year period whereas the interest income from the retail government bonds is taxed on an annual basis during the 10-year period. The effect of compounding in the government retail bond investment is reduced due to the annual tax bill that must be paid on the interest income for that year which reduces the amount that is available for reinvestment for the rest of the investment period.

The highest 10-year after-tax investment return of R1 436 093 is earned in the unit trust investment followed by the retirement fund and government retail bond investments with R1 115 619 and R1 065 800 respectively. The superior after-tax returns of the unit trust investment are due to the R40 000 per year capital gain tax exemption that was triggered for a period of seven years thus reducing the taxable capital gain to R1 313 742. A further factor is the fact that the capital gains are only taxed at an effective tax rate of less than 10% as only 40% of the capital gain will be taxed at a rate of 30% after 10 years whereas the full annuity income taken from the retirement will be taxed at 30% when it is paid to the pensioner.

It might therefore be more beneficial, from a tax perspective, to invest extra money, that does not qualify for an upfront retirement fund contribution tax deduction, in an investment vehicle that produces capital gains rather than interest or investment income within a retirement fund. On the other hand, the investment income in a retirement fund is protected against your creditors and it does not attract estate duty upon your death when the money is transferred to your dependants and nominees.

What might appear to be the logical choice when viewed in isolation might look vastly different when compared to other options. It is always wise to consider consulting with a financial advisor who can guide you through the different investment options to arrive at the option that is best for you taking all your personal circumstances and not only tax considerations into account.

* Ladouce is a pension funds lawyer and the author of the book, Pensions for Palookas.

PERSONAL FINANCE