Wealth is normally associated with the amount of financial capital you have accumulated, whether it is property, investments and/or other assets. There is however another important form of wealth that is often overlooked, namely your human capital. Human capital is a combination of your knowledge, skills, talents and behaviour that you grow through education and experience. From an economic perspective human capital is your potential to earn an income that over time can be converted into financial capital through saving. This financial capital in return has the potential to grow if it is appropriately invested and should provide the necessary income when you are no longer able to earn a salary. The graph below illustrates this process.
As a professional your career (1) from a financial capital perspective will likely consist of the following three stages:
- Foundation phase - when you have just started a career and your human capital makes up nearly all of your wealth (1). If you are employed by a corporate you would start contributing to your retirement savings. Shorter-term financial goals would include buying (most likely using debt) a motor vehicle and your first property. A large portion of your salary will go towards necessities and paying off debt such as study loans.
- Building phase occurs when your career has progressed to the stage where your salary increased and your financial capital steadily becomes a larger portion of your total wealth. (2) At this stage of your life you may have some life events such as marriage and considering starting a family, which will place some demands on your disposable income. During this phase the marginal tax on your income increases steadily.
- Compounding phase occurs over the final 10 to 15 years of your career when your financial capital steadily becomes the majority of your wealth (3). Over this period you benefit from the compounding effect of your current savings and from a higher contribution rate to your savings because you have more disposable income. You will most likely be a high marginal tax payer who needs to consider tax implications on discretionary (non-retirement) savings.
Maximising your tax benefits
One of the challenges of saving during the foundation and building phases of your career is balancing your shorter-term financial needs against longer-term retirement needs. Quite often when employers don’t provide a retirement fund option, employees select to rather use their salaries to pay off debt or cover other shorter-term expenses and place savings into discretionary savings products. This can potentially put a lot of pressure on your finances prior to retirement as you will have to save significantly more over the final years of your career. Additionally, over the span of your career you would not have benefitted from the tax deductions on retirement savings and the compounding of these benefits.
In March 2016 National Treasury changed the way that tax deductions are calculated on retirement contributions. The total allowable retirement contribution limit was set at 27.5% of an individual’s total remuneration or taxable income (whichever is highest) but is capped at R350 000 per annum. Any retirement contribution above this limit will not enjoy an income tax deduction1.
In the table below we have quantified some of the shorter-term tax advantages to contributing to a retirement fund for different marginal taxpayers. We have made the following assumptions:
- You save 27.5% of your annual remuneration and compare different splits between retirement contributions and additional discretionary savings against purely saving outside a retirement fund.
- We have excluded the structure of the salary package and other deductions such as medical aid, UIF etc. as they are the same under the different savings scenarios.
- Calculations use the income tax rates for under 65-year-olds.
During the foundation phase of your career the tax benefit is not as much as during the later phases when marginal tax rates are higher. At the early stage of your career it therefore makes sense to balance your savings between retirement contributions and shorter-term investments. Then as you progress into the building phase and your disposable income increases, retirement contributions can be increased to benefit more from the tax savings. One possible strategy (see green highlighted blocks in the table below) is to increase the retirement contribution when you receive a salary increase, especially when the new salary falls into a higher tax bracket. This should allow you to increase your savings rate without reducing your monthly disposable income as the tax benefit should partly offset the increased contribution.
Implementing the tax-efficient strategy
Retirement savings don’t only benefit from tax deductions on contributions but are exempt from the taxes on the growth of an investment such as dividend tax, income tax on interest-bearing instruments, and capital gains tax. There is therefore a big tax benefit to your retirement savings over the short and long term; the former allows you to save more while the latter allows the savings to grow more and benefit from long-term compounding.
In the table below we have quantified the long-term tax savings when you invest in a retirement fund structure. In a previous article2 we discussed constructing a life-stage strategy that takes an individual’s human capital into consideration when determining the correct asset allocation for a retirement portfolio. If you have a lot of job security (safe human capital) during the foundation and building phases of your career, you can use an aggressive balanced fund until around 10 to 15 years prior to retirement when your remaining human capital is roughly equal to your financial capital (by which time you are more likely to be a high marginal taxpayer). Once you are in the compounding phase of your career you can transition first into a traditional balanced fund and finally into a conservative balanced fund prior to retirement. We have highlighted the relevant tax savings in different shades of orange over the different life-stages.
The annual tax benefit on the returns achieved is lower in the aggressive and traditional balanced funds because they hold less interest-bearing asset classes such as bonds and money market funds, where the interest is taxed at an individual’s marginal tax rate. Over a 35- to 40-year career these annual tax savings can compound significantly, especially since no capital gains tax is paid when retirement savings are transferred to a living or life annuity.
Contributing towards your retirement
There is a number of different ways you can contribute towards your retirement; the two most common are employer-based pension schemes and retirement annuities (RAs). Employer-based pension schemes allow for different contribution rates so you can steadily increase your retirement contribution rate over time. The tax deduction on your contributions to employer schemes will be an immediate benefit as it is taken into consideration when calculating your take-home pay. After the March 2016 changes some employer schemes also allow for ‘additional voluntary contributions’ above the pension scheme's current maximum contribution rates (e.g. 21.5% of pensionable salary, which is around 15% of total remuneration) to allow you to make use of the full 27.5% contribution limit. These top-ups will also enjoy monthly benefits from the tax deduction on the increased contributions.
If an employer does not offer a pension scheme or an additional contributions option, you can make use of a retirement annuity. The tax deduction will however only be paid once you have filed your tax return, which is normally more than six months after the financial year-end.
Bridging the gap between your short-term financial needs and your future retirement income requirements can be challenging, especially if you don’t have a savings strategy. In the analysis above we illustrated how you can find a balance between these two requirements by progressively utilising you tax benefits as your career progresses and your salary increases. If implemented properly it should be able to significantly increase your chances of retiring comfortably.