Be the master of your own retirement!
Planning for a rich life when you're old.
July 9, 2003
For many of us the last thing we want to think about is old age and eventual retirement. Living our lives and enjoying the lifestyle that we have become accustomed to does however have very real implications on how we plan for our golden years. Retirement planning is all about making informed decisions. There are numerous options and time is on your side when you are young. There are several ways you can save money and several ways to access that money.
The three most common devices are:
You could combine all three to save and once you retire, you can access your money as a lump sum or monthly, in the form of an annuity or pension.
Alternatively, you can live off the interest from a savings account.
If you start saving from the day you start working, time will work to your advantage in the following ways:
Flexibility - you will have the time to accommodate changes to your plans or lifestyle, that new and all too impractical sports car, the perfect gift for the love of your dreams or the sudden desire to study art and live life in retreat nestled in the shadow of Table Mountain in your 40's . For this you will need to consider changes in inflation, taxes, medical costs, investment costs and any other of life's little surprises.
Investment choice - certain investments, such as unit trusts and the share market, work better over the long term. Over the past 25 years, the Johannesburg Securities Exchange's (JSE) All Share Index has provided investors with returns of 22 percent, but over the past seven years investors on the JSE have had a bumpy ride.
Tax rates - these are reducing from year to year and different taxes affect your investments, depending on the way you save your money.
Compound interest - this works to your advantage over the long term. If you save R1 000 a month for 25 years, escalating the amount by seven percent a year, and at an interest rate of 11 percent a year, you will have R2.6 million in 25 years. And you will have contributed only R800 000. (Tax is not considered in this calculation.)
Time and rand-cost averaging - time reduces the risks that you take in the short term. You only benefit from rand-cost averaging when you invest on a regular basis. When you invest every month in a pension fund or investment, the prices of the underlying investments (such as shares or unit trusts) vary. Over time, the average cost of a regular investment is lower than the average cost of a once-off investment.
The taxation of investments will influence your choices when it comes to how you want to invest. Some investments can be made with pre-tax money, while others can only be made with post-tax income.
Pre-tax investments are instruments such as provident funds, pension funds and retirement annuities.
After-tax investments are home loans, property, endowments, shares or unit trusts, income plans, money market or fixed deposits, offshore investments and hedge funds.
Remember that contributions to pension funds and retirement annuities are tax deductable up to a limit whereas contributions to a provident fund are not tax deductable but you can take the entire amount as a lump sum when you retire. The contributions that you made to the fund are not taxed at retirement.
You can therefore save up to 40 percent on tax by contributing to a pre-tax saving vehicle. For example, if you earn more than R240 000 a year, every rand above that amount is taxed at 40 percent. If you invest your money in a pre-tax saving instrument, such as a retirement annuity, the whole amount is invested. If you invest money in an after-tax instrument, such as a basic savings account, you will pay 40 percent tax on the income, leaving only 60 percent of your money in savings.
You can move your pension fund money from your employer's fund to your new employer's fund, without having to pay tax.
As all pension funds are taxed at 25 percent, ff the tax rate on your investment savings is more than 25 percent, then you save on tax by putting your money in your pension fund. When you retire, you are entitled to withdraw a once-off lump sum from you pension fund, part of which is tax-free. The balance of the lump sum will be taxed at your average tax rate. If you transfer your pension into an annuity fund, the transfer is tax-free. But the monthly pension you receive from the annuity fund is taxable.
Pay tax now or later?
If you invest R1 000 in a pre-tax vehicle for 25 years, with your contribution escalating by seven percent every year and the investment earning you an 11 percent return, you will save over R2 million. However, R1 000 invested in an after-tax savings instrument at a tax rate of 38 percent (assumed marginal rate) will only save you R1.5 million after 25 years, this of course, assuming your contribution escalates by seven percent a year and the investment earns you 11 percent interest every year.
The trend of decreasing personal taxes bodes well for future tax rates. When comparing the tax rates of 1995/6 to 2002/3, there has been an annual 4.5 percent reduction in annual tax rates. If you are paying the top marginal tax rate of 40 percent now, you may well be paying less tax at retirement, so it may well be worth your while to defer taxation by investing in a pre-tax retirement fund.
One interesting way to provide capital is to use your home loan. When paying extra money into your home loan, you can later access the capital to cover study costs and other such expenses. When you repay this withdrawal, it will be at the interest rate you are charged on your home loan, which is generally the cheapest form of loan there is. You will also have saved some interest on your loan while the extra payments were still in your loan account, before you accessed it for education costs.
Remember however that charges on investments will also affect the eventual outcome and that there are exit and ongoing fees on investments. A high 'upfront' fee and low 'ongoing' fee is cheaper than a low 'upfront' fee and a high 'ongoing' fee.
Another important note is that pension and provident funds, preservation funds, retirement annuities and living annuities are all exempt from Capital Gains Tax (CGT) for three years from the introduction of CGT in October 1, 2001. This exemption may be extended.
As investors, we should always be informed by reading newspapers and talking to people. We need to be able to identify opportunities in the market and avoid pitfalls and always invest within our own risk profile. The younger you are, the more risk you can afford, but the closer to retirement you are, the more conservative you should become. Also, diversify investments and do not invest all your money in one product.
One thing that may be hard at first is to be realistic and reasonable in your expectations. Investments will grow over time, not overnight so the key is discipline. This may mean rethinking how you spend your money each month to make sure that you have something each month left to invest! At retirement, make sure you can access your money. Some forget that the point of a retirement plan is to take care of your financial needs at retirement and not to leave a legacy for your heirs.
Once you have made the decision to do something positive with a view to your retirement, seek professional advice and communicate with your adviser frequently to review your plan on a regular basis and to make cost comparisons and monitor your investments. Who knows, today may be the start of a rich and rewarding future! –QFN
For a free personal assessment of your financial risk profile, your retirement plan or a general portfolio assessment, email us.
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