Tax-free savings account or retirement annuity?

Tax-free savings accounts (TFSAs) and retirement annuities (RAs) are tax-efficient products that can assist you with long-term saving.

In this article, we provide a basic overview of the purpose and benefits of each.

Tip: Learn more about the value of saving and investing for your future.

Understanding how to save for retirement with retirement annuities and tax-free savings accounts

What is a tax-free savings account (TFSA)?

TFSAs exempt account holders from paying tax on any interest, dividends, or capital gains their savings may otherwise attract. This holds true provided the account holder doesn’t exceed the contribution limits of R36,000 a year or R500,000 over their lifetime.

Different types of TFSAs cater to customers with different risk profiles. These range from fixed deposit accounts to investment accounts that allow you to invest in unit trusts, exchange-traded funds, retail savings bonds, and linked investment instruments via linked investment service providers (LISPs).

Is a tax-free savings account better than a regular savings account? 

TFSAs are superior to a regular savings account, in that they attract zero tax on growth and returns, which means you can earn and save more.

For example, if you invest R30,000, and it grows to R60,000, the R30,000 growth would not be taxed, as it would be if it was earned in a traditional savings account. You would instead receive the full R30,000 benefit – an advantage for savers. 

How does a retirement annuity (RA) work?

An RA permits you to accumulate capital that you can access once you reach the age of 55 years. It’s generally an alternative retirement vehicle for someone who is self-employed or works for a company that doesn’t offer a retirement scheme.

“You can make regular contributions to an RA, which are tax deductible up to a limit of 27.5% of your taxable income, but not more than the maximum amount of R350,000 a year,” says Marc Joubert, an independent financial adviser at Oracle Broker Services.

“You can still contribute more than that if you are able, and the amount over the limit will be added to your tax-free limit on your one-third lump sum withdrawal at retirement.”

Understanding the types of RAs in South Africa 

As a type of retirement fund, an RA is regulated by the pension funds act.

There are two types of RAs to choose from – underwritten RAs, which are also regulated by the long-term insurance act, and non-underwritten RAs.

A registered financial adviser can advise which option would best suit your retirement needs, considering factors such as costs, time to retirement, and your overall financial position.

Is a retirement annuity preferable to a pension or provident fund? 

The incoming two-pot retirement system will reduce the difference between RAs and pension or provident funds. Membership conditions will be the only differentiator.

Currently, individuals choose to invest in RAs and can select their contributions, while occupational funds are subject to the terms and conditions of employment.

Can I withdraw from a retirement annuity? 

An RA is independent of your employer, so you can continue contributing to it even if you change jobs. However, you can’t withdraw your funds before age 55, unless you have less than R15,000 invested, or meet additional criteria: “If you are permanently disabled, or you have been living in another country for three years and have non-residency status in South Africa, you can withdraw your funds,” notes Joubert.

The two-pot retirement system will permit you to access a portion of your savings once a year. However, this should only be done in an emergency.  

Once you retire, you can withdraw up to R550,000 as a lump sum, tax-free. The remaining amount will be taxed according to retirement benefits tax tables.

What is the difference between a tax-free investment and a retirement annuity? 

Tax implications 

A TFSA can be considered a mini tax haven when saving for retirement, as you can store funds in a TFSA and not be taxed on them.

By contrast, even though the funds in your RA aren’t taxed, you will be taxed on the total amount once you withdraw the funds after age 55.

Accessibility of funds 

A TFSA is a flexible product as you can invest in growing an income but also access the funds if you need to, says Joubert.

While this may be helpful in an emergency, it may also prevent you from saving for the long term. Further, it may tempt you to “time the market” if your investment returns appear low, which could compromise long-term growth.

“The longer you invest, the greater the compound effect of tax-free growth,” says Munaf Mukadam, wealth manager at Gradidge-Mahura Investments.

“A withdrawal from your TFSA will not increase your annual (R36,000) and lifetime (R500,000) limits; therefore, a withdrawal reduces the compound effect of tax-free returns as you won’t be able to re-contribute that amount.”

The pros and cons of using a tax-free savings account for retirement savings

Advantages of a TFSA  

A TFSA will make a big difference in the growth of your wealth over time, which will allow you to retire more comfortably.

You are not liable for the tax to be paid out of your income or the proceeds of your investment, says Joubert.

Disadvantages of a TFSA  

There is a cap on your tax-free savings because of the annual and lifetime limits. If you exceed the R36,000 limit during the year, a 40% tax penalty will be applied by the South African Revenue Service (SARS).

Clients may use a TFSA for short-term savings, but this is not advisable. “If you invest for the short term, it is risky to invest aggressively as market volatility could go against you when you withdraw funds,” Joubert warns.

The pros and cons of using a retirement annuity for retirement savings

Advantages of an RA 

Contributions are tax-deductible and the growth within an RA is tax-free. “The tax you would normally have paid on the income used to fund those contributions will be credited to you and either refunded or offset against other tax you owe,” Joubert notes.

Samukelo Zwane, product head at FNB Wealth & Investments, says you can contribute as much as you like to an RA – there is no annual limit, as there is with a TFSA.

“You can accumulate more money in an RA over a short time and still have the tax-deductible benefit, which rolls over to the next year if you’re above the deductible limits for a particular year.”

Disadvantages of an RA 

An RA must comply with regulation 28 of the pension funds act, which limits where you can invest your savings. This may restrict your growth, but prove less risky.  

Once you retire, you’re only allowed to access a maximum of one-third of the investment as a lump sum, while the remaining two-thirds must be reinvested. However, this “disadvantage” is an advantage in that you won’t be tempted to erode your savings.

Although tax payable is deferred until you retire, it will be far lower than the amount of tax you save on the income tax deduction, and tax you would otherwise have paid on investment growth.

Making the best decision for your retirement savings 

Ideally, you should contribute to both a TFSA and RA, which will boost your tax-free savings. Joubert recommends that you invest as much as possible, as early as possible, for as long as you can. 

“Stick to unit-trust-based TFSAs and RAs, if possible, because they are lower cost, transparent in their reporting, and carry no penalties for reducing or stopping contributions,” he explains.

The costs of a new-generation (unit-trust-based) RA and a TFSA – including administration, asset management and advice fees – are largely comparable. However, they may differ depending on which platform you use.

Tip: Is debt preventing you from saving enough for retirement? Find out how debt consolidation can help.