Q&A: Tax efficiency of paying into a retirement annuity
You still get a RA tax deduction even if you have cashed in your pension
Q: Following on from your Q&A headlined “How does tax-free severance pay work?” I would like to ask about the tax efficiency of paying into a retirement annuity (RA). If the combination of a severance package and cashing in my pension savings has taken my tax rate on lump sums to 36%, is there any benefit in paying into an RA if my current marginal tax rate is about 25%? Or will it be tax efficient only if I do not take a lump sum from the RA and convert all of it to an annuity after retirement? — Kim DP via e-mail
A: Janet Hugo, independent financial planner at Sterling Private Wealth, replies:
The issues you need to consider are that if you contribute to an RA you will still enjoy a tax deduction on your contributions to the fund. This means a quarter of your contribution within the maximum tax deductions allowed can be funded by what you would otherwise pay as tax.
What you contribute to the fund will then grow free of tax on the interest, dividends and capital gains.
When you reach retirement, though you have exhausted your tax-free amount on previous withdrawals and a severance package and will therefore pay a high rate on any lump sum withdrawal relative to your current tax rate, you don’t have to take a lump sum.
You can as you suggest use all of your savings to buy a pension. That pension will be taxed as and when you receive it, but if you only retire after age 65, your tax rate will be lower as you enjoy the secondary rebate, higher tax credits for medical scheme contributions. In addition, your pension is likely to be lower than your current income, which means the income tax rate will also be lower.
The biggest problem you are likely to face in not withdrawing a lump sum is that you will have no savings for large expenses you may face in retirement such as a new car, maintenance at your home or medical expenses.
It would therefore be a good idea if you do not have other savings to save money outside your RA, possibly in a tax-free savings account, for this purpose. However, though you enjoy tax-free growth on investments in such an account, you do not enjoy tax deductions for any amount you save in a tax-free savings account.
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