SARS’ tax-deductibility cap of R350 000 per year on contributions to retirement funds poses a key question for high-income earners. The first thing to remember is that the limits imposed on the tax deductibility on retirement contributions doesn’t mean there’s a limit on retirement contributions.

Should they continue to contribute a percentage of their salary towards a retirement fund (or retirement annuity) even though it has exceeded the cap? Or does the fact that these contributions aren’t tax-deductible upfront mean they should contribute up to the limit, and then allocate excess contributions towards discretionary savings? This could include a tax-free savings vehicle to limit tax on savings growth.

Old Mutual Corporate Consultants (OMCC) conducted a thorough investigation into this topic to assist high-income earners.

Understanding tax breaks on retirement savings

Different types of retirement savings vehicles, whether a retirement fund or annuity, discretionary savings vehicle, or tax-free savings account, have different tax treatments, as per the table below:

Saving inside or outside of your retirement fund

Once the contributions for a particular tax year reach the cap of R350 000, any further contributions above this level do not qualify for an upfront tax deduction, so excess contributions will be paid from after-tax income.

The growth within the fund will still be tax free, and the contributions not deductible during the period of membership will reduce the taxable amount of the lump sum payable at retirement – therefore they will increase the tax-free amount available.

Any non-deductible contributions not “used up” in this way (i.e. applied against the lump sum payable upon retirement) may be applied to reduce the taxable amount of any annuity income that becomes payable during retirement.

It isn’t obvious that this treatment would be more beneficial as opposed to either a pure discretionary vehicle or a tax-free savings account.

When comparing possible savings approaches, remember to not only consider the impact that taxation could have on your future retirement goals but also the type of investment vehicle one should use.

In evaluating which investment vehicle to use, it is important to recognise that there are a number of factors, outside the obvious tax advantages that you need to keep in mind.

One of these is the fees associated with investing in a ‘retail-type’ savings product versus investing in ‘institutional’ products. Paying higher fees can diminish investment returns drastically over the long-term.

Another factor is having exposure to offshore markets. Retirement funds are now able to invest up to 45% of the total contributions offshore. Initially, the move to invest at the limit was slow but now we see more asset managers taking advantage of this higher limit in search of superior investment returns.

Moreover, consideration must be given to the estate duty implications. Excess contributions are not exempt from estate duty but may be a source of liquidity that can be used efficiently.

Additionally, consideration of how retirement savings are distributed upon death must be factored in, as savings are subject to Section 37C of the Pension Fund Act and therefore distribution of the retirement savings is at the discretion of the Fund Trustees.

Lastly, being able to access your investments should the need arise. Given the pending implementation of the new Two-Pot Retirement System, the last factor may be a deterring one for investing in a retirement fund as members will be able to access a portion of their future contributions should the need arise. Note that excess contributions will also be split according to the Two-Pot rules.

To evaluate the impact, we compared three different scenarios.

The actual tax impact will vary based on your personal circumstances, e.g. level of income, salary increases, amount and timing of savings, type of pension or drawdown and timing of realising capital gains. It's important to also note that the investment portfolios used in the analysis have a similar underlying asset allocation.

Our scenarios are:

1: Saving the excess in a retirement fund – inside a retirement fund

2: Saving the excess in a discretionary savings vehicle – outside a retirement fund (no tax-free savings account)

3: Saving the excess in a tax-free savings account (TFSA) until the limit is reached, and then in a discretionary savings vehicle. Lifetime limit adjusted by inflation and saving outside of a retirement fund, with a tax-free savings account adjusted according to lifetime inflation

As people who earn higher salaries pay more tax, there are significant tax differences among the three scenarios.

Scenario 1: Starting salary before tax of R2 534 000 per year, contribution of 15% to retirement savings

At this level of income and based on a contribution of 15% of salary, the difference between contributing the excess over the R350 000 cap towards a retirement fund versus using discretionary or tax-free savings vehicles is insignificant.

Excess contributions are small, and the cap has only just been breached. The take-home pay for the scenarios using a TFSA (scenario 3) is only marginally better (about 4%), than contributing the excess to a retirement fund.

Scenario 2: Starting salary before tax of R2 534 000 per year, contribution of 20% to retirement savings

Working with the same gross salary but increasing the contribution to 20%, the difference in tax treatment becomes more pronounced as there is a larger amount above the R350 000 cap (total contributions would amount to R506 800 per year).

In this case, saving the excess contributions inside a retirement fund will lead to a post-tax income in retirement of about 9% more than saving outside the fund; and 3% more than if a TFSA is used (although this gap does close with the time spent in retirement).

Scenario 3: Starting salary before tax of R5 000 000 per year, contribution of 15% to retirement savings

For a higher level of income of e.g. R5 000 000, the merits of contributing the excess towards a retirement fund are more significant. The monthly net-of-tax income in retirement of R133 794 is initially about 15% more than that generated by using a discretionary vehicle, and just 10% more than if the contributions were directed towards a combination of a TFSA and discretionary savings.

Note that this gap does close as retirement progresses as the amount of tax paid on growth within discretionary savings vehicles reduces as the income drawdowns reduce the capital.

The bottom line

Notwithstanding the caveat that the actual tax impact will vary from person to person based on their specific personal circumstances, the analysis finds that contributing in excess of the cap towards a retirement fund produces a superior level of post-tax income in retirement, despite the fact that the excess contributions are not tax-deductible.

As an aside, whilst some readers may question whether 35-year-olds earn over R2 million per annum, the findings hold irrespective of a member’s age – with the difference being the sum of money available at retirement (a longer investment time horizon can lead to better retirement outcomes).

In summary, using a retirement fund efficiently offers:

• significant tax benefits
• the possibility of having almost half of your investment allocation exposed to offshore markets
• and post 1 September 2024, the opportunity to be able to access a portion of your retirement savings.

We also find that using a tax-free savings account does improve the situation relative to the use of plain discretionary savings vehicles, but this is still not enough to justify using this vehicle ahead of allocating the excess contributions to the retirement fund.

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