Can I get tax benefits from contributing to my kids’ RAs?
Anyone who contributes to a pension fund or retirement annuity (RA) is entitled to claim a deduction for tax purposes based on their contribution, subject to the limitations applicable at the time of the contribution. However, the fund or annuity must be in their name. So while you can contribute to an RA in the name of your child, you would be unable to claim a tax deduction on the contribution.
How can you still claim the tax deduction?
A possible alternative is to open an RA in your personal capacity with the intention that, upon your death, that particular RA passes to your named beneficiaries, which in this case would be your children. In this instance the contributions would be tax deductible subject to the limitations.
In this example should you have a claim made against you in the event of a divorce, the RA may be open to a judgment by the courts, despite the fact that you initially intended it to be for the sole benefit of your children.
Similarly, in the event of your death, should the pension fund trustees find that you have a financial dependant, they have the ability to provide for that dependant before considering the named beneficiaries of the RA.
Although these may seem unlikely scenarios at the time of opening an RA in your name (should that be your chosen route) you must be aware of the possible eventualities that may affect your overall intention.
According to current legislation, on your death your named beneficiaries will have the choice of taking the value of the RA as a discretionary lump sum (to invest or spend as they see fit) or to have the RA transferred into their name where they can eventually turn it into an annuity income. You are unable to specify how your named beneficiary is to receive the benefit.
My first priority is to help provide for my children’s retirement
As mentioned, you can contribute to a RA in their name which is secure from creditors and inaccessible until age 55. The RA can invest in different asset classes to differing degrees. This may include high growth or conservative growth. This is an option to consider as it has the benefits of growing tax free and is protected from creditors.
The legislation that governs the restrictions in terms of what the underlying investments may be within a pension fund is commonly referred to as Regulation 28. This controversial regulation restricts the amount of growth assets that can be included in the RA. If the investment is to be invested for a period of 40 years, it may be worth considering the use of a tax-free savings account. The benefit of a tax-free savings account is that it grows tax free, as an RA does, but is not required to invest in compliance with Regulation 28.
In the case of a fund that is compliant with Regulation 28, they may only have a maximum offshore exposure of 30%. Over a 40-year period it may be more appropriate to have an unconstrained mandate that can diversify into more companies listed around the world, which may have higher growth potential than South African asset classes.
The disadvantage of having a tax-free savings account as a retirement savings vehicle is that the money can be withdrawn at any point in time by the account holder. This gives the investor the temptation to use the money should they wish to spend it in circumstances that can be considered non-essential, such as home renovations.
What would a small contribution look like over a very long period of time?
The following scenario is an example of how powerful compounding can be over a very long period of time. Consider a relatively small starting contribution of R500 per month, escalated annually by inflation over 13 years to reach a total nominal contribution of R78 000. Given a realistic return target of inflation plus 5%, the total equivalent contribution of R78 000 grows to R593 154 (all quoted in today’s value of money).
|Starting age||Eight years old|
|Investment time horizon (years)||57 years (to age 65)|
|Nominal annual return after unit trust fees||11%|
|Net annual return A number of well-known South African managers have consistently outperformed this benchmark with their balanced funds over a long-term time frame||Inflation + 5% (considered to be a realistically achievable target over such a long period of time)|
|Starting monthly contribution||R500|
|Contribution period||13 years (to age 21)|
|Annual escalation of the starting contribution||6% (inflation)|
* No financial advisor or platform fees have been included.
|Nominal return (the rate of return on an investment without adjusting for inflation)||R16 428 659|
|Real return (a real rate of return is the return on an investment that has been adjusted by inflation)||R593 154|
Source: Allan Gray Financial Planning Tool
At the age of 65, the investor would have just less than R600 000 in terms of today’s value of money, which they can add to their retirement saving in order to produce an income in retirement.