Buying a retirement annuity only to save tax is not a great idea

Buy a retirement annuity to save tax! Retirement annuities are a great way to neutralise tax! Save tax now, buy a retirement annuity.  Save tax by investing into a retirement annuity before 28 February.  Your last chance to save tax before 28 February.

I lost count of the number of times I read this everywhere on social media the last few weeks.  There were many variations of these headlines.  But they all had one thing in common.  They all try to seduce clients into putting more money into their RA’s or buy a new RA… to save tax.

The worst idea ever.

Are these headlines lying?

The simple question to ask next is, does a taxpayer receive a tax deduction when contributing to a retirement annuity?  In other words, does contributing to a retirement annuity save a taxpayer tax?  Well, the answer is yes, yes it does.

So why then do I say that it is the worst idea ever?

Intent

The intent of the headlines is to help clients pay less income tax.  A very noble goal.  However, history has proven that where the intent of a taxpayer was to avoid paying tax (in any form) has, more often than not, back-fired on clients (and advisers) in the long-term.

In our tax practice, I often have clients asking me how they can save tax.  It is clear from many discussions that clients want to pay as little income tax as possible.

Whenever SARS is auditing or questioning a taxpayer’s tax affairs, they always look at what the intent of a certain transaction was.  If the intent was to avoid income tax, then chances are that a deduction may not be allowed.

Clients ask if they should…

We often get clients that own rental properties and who made a profit form the rentals, if they should increase their bond to pay less tax on the rental income.  The reason is that the interest on the bond is deductible against the rental income, therefore reducing the taxable income.

Let’s consider the intent and the impact of this.

The intent, clearly, is to pay less income tax.

To consider the impact, let’s assume the client earned R 100 000 profit from rental income.  The tax will at the most be R 45 000 (45% marginal tax rate).  The client re-bonds the property and now pays interest of R 100 000 per annum.  This is now an expense that can be deducted from the rental income received, leaving the client with no profit and therefore no tax payable.

It looks like the client’s problem is solved.  However, before re-bonding the rental property, the client had a net profit and net cash flow of R 55 000 after tax.  Should the client re-bond the property, the tax will be zero, but the client will now pay R 100 000 to the bank for the interest.  This leaves the client with zero profit and zero cash flow.  Not a great outcome.

What does this have to do with a retirement annuity?

The point I am driving home is that whatever you do to save tax, you will never save more than 45% of what you spent.  Put in simple terms, the client paid R 100 000 to save R 45 000 in the scenario discussed above.  Does it make sense?  No, it doesn’t.

What would have made sense is if a client spent R 45 000 and saved R 100 000!  Alas, that is not how the tax system works.

The same applies to buying a retirement annuity with the intent to save tax.  The only difference here is that at least the money goes to your own investment and not to someone else.  So what is the problem then?

The problem

There are a few questions that are not being asked, nor answered:

• What type of retirement does the client envision?
• How much does the client need for retirement?
• Is a retirement annuity the best (or only) solution?
• Should the money used for contributions not rather be applied to other areas of the client’s financial planning?
• What if the client requires access to capital, as is often the case for business owners?
• How will the tax saving be used?

If the only reason the client is doing something, is to avoid tax (even through legal means), then that is the problem.

The golden rule

I have been sharing my golden rule as part of my Personal Income Tax for Financial Planners course:

Never do anything to save tax.  But whatever you do, do it as tax efficient as possible.

What does this mean practically?  The goal is more important than the tax you pay.

Let’s stick to the retirement scenario.  If it is determined that the client is not on track to have sufficient provision for retirement, then a strategy or plan must be implemented.  What would be wise, is to consider the options available to the client to boost their provision as much as possible.  One of which is the tax deduction that can be claimed when contributing to a retirement annuity.  The client can invest the tax refund they receive to further boost their retirement provision.

Using the same numbers as earlier.  The client contributes R 100 000 to a retirement annuity and receives a R 45 000 tax refund.  Most people will view it from the angle that the client only invested R 55 000 of their own money and then spend the tax refund on something else.  Whereas the client could take the R 45 000 and also invest it into the retirement annuity, making their contribution R 145 000 for the year.  See how this now boosts the client’s retirement provision?

The right intent

When the intent is to provide for retirement, rather than avoiding tax, it makes sense.  Whatever happens to legislation, the intent and goal do not change.  The goal is clear, what needs to be done is clear and the client is making the most of current tax breaks afforded to them.

Always ask why.  If the only intent is to avoid tax, then the danger signs must go up.  Help the client move their intent from avoiding tax to achieving other goals they have in life.  The outcomes will be far better.

Instead of urging clients to buy a retirement annuity so they can save tax, we should rather be urging clients to review their retirement planning and how they are tracking!

A final thought

As a last point, when clients were advised to move money to retirement annuities to save on estate duty (a brilliant plan at the time), what happened?  The legislation was changed to include any excess rollover contributions (also called previously disallowed contributions) that exist on the death of the taxpayer, as deemed property in their estate.  So not only is the plan that was devised with the intent to avoid (or save) tax not effective anymore, but the client is now locked into the retirement annuity with virtually no access to their capital.

This clearly demonstrates that having the single intent to avoid tax, is not the best approach to financial planning.