Is it possible to retire tax free?
By Lizelle Steyn
19 May 2023
Photo credit: cottonbro studio
The ideal retirement can be a bit like a game of Monopoly: we all want to pass "Go" without collecting any pesky taxes along the way. So, picture this: you're strutting down the street, sunglasses on, Panama hat tilted just right, a spring in your step, and a grin on your face because you have discovered the secret to retiring without paying any income tax.
Ten years ago this wouldn’t have been possible. The only long-term investment products used were retirement funds, of which the income drawdown is taxed like it’s a salary paid into your bank account, and share portfolios, on which you pay capital gains tax when cashing in to live from the money. Fortunately, the arrival of tax-free savings accounts for long-term investing has changed everything.
But, is it really possible to retire tax free?
Scenario 1: Yes, if you can live off R18 000 per month in retirement. To save up enough, but not so much that you end up paying tax on retirement income, my calcs show you would need to do the following: early in your career, start maxing out your R36 000 annual tax-free account allowance every year until you reach your R500k lifetime allowance, and then just leave the money in the investment account until the end of your 35-year investment journey. You would also need to start investing R36 000 per year in a retirement product (your company’s fund or your own private retirement annuity) from year 6 of your investment journey, and steadily increase your retirement fund contribution as your skills develop and you get promoted. Keep this up until the end of your 35-year journey.
With the assumptions I’ve used, you’ll end up with around R2.6m in your TFSA and R2.95m in your retirement fund. (I’ve worked the large future values after 35 years back to what those amounts would be worth today.) From your TFSA balance, you'll simply withdraw 4% per year - always tax free. The retirement fund part needs a few more "tricks" to avoid paying income tax. At retirement, you’re allowed to take R550k from your retirement fund in cash at zero tax. Do that and split the R550k between money market and equity instruments, with a small enough amount in money market so you don’t go over the R23 800 annual interest exemption. If you put the remaining R2.4m retirement fund money in a living annuity and withdraw 4% per year, you’ll be close enough to the annual SARS income tax threshold (R95 750) to not have to pay income tax. And voila, you’ve bid farewell to income tax.
To recap, in retirement you’ll be drawing 4% every year from:
- Your tax-free savings account
- The money market-equity split of the R550k you took tax free from your retirement fund
- Your living annuity, which you bought with the remainder of your retirement fund
What if you can’t live off R18 000?
Scenario 2: If R18 000 is too tight for you, you have other options. Firstly, you can wait a few years longer before you retire, allowing your money to grow. But then, in retirement, you’ll have to draw slightly less than 4% from your living annuity portion to stay under the SARS income tax threshold of R95 750 per tax year. And make up for that by withdrawing more than 4% from your TFSA. Fortunately, the law allows you to withdraw up to as little as 2.5% per year from a living annuity.
Scenario 3: The assumptions I made in scenario 1 were conservative. The reality is that the R500k TFSA lifetime limit will probably be increased to allow for the fair treatment of investors starting out in, say, 2030. By then, R500k will be worth only half of what is was worth to investors when TFSAs were launched in 2015. Assuming that you can just continue investing R36 000 per year for the full 35-year journey (and that’s still conservative assuming the R36k annual limit stays constant), then you end up with significantly more in your TFSA after 35 years. If you follow the same 3-step portfolio approach as in Scenario 1, after 35 years, a 4% drawdown on all 3 components of your portfolio will give you nearly R21 000 per month to live from tax free. If the R36k annual limit gets raised (which is highly likely), you’ll be able to draw even more in retirement.
Not bad in a country where the average salary is R26 032 per month. And before retirement, a large chunk of your salary goes towards wealth building, either by repaying home loans and/or investing for retirement. Post retirement, those debit orders should disappear from your list.
If you’ve been reading this blog for a while, you’ll know I don’t believe in traditional retirement, as in abruptly cutting off all active income. Instead “retirement” is a time to start earning an income from things you love, knowing you have a financial freedom portfolio to provide a roof over your head, medical aid membership, and food on the table for the rest of your life. The portfolio described above is your safety net – the financial support structure you’ve built for yourself. By all means, keep on earning an income to keep yourself mentally fit, socially well integrated and provide funds for life’s luxuries – and to help others because you may end up having more than you need.
Does it have to take 35 years?
You can reach financial freedom sooner if you invest more than the figures mentioned in these scenarios, as long as it's not into your TFSA, or you'll incur the 40% penalty on the excess. (Our scenarios assume you're already maxing out your allowable TFSA contribution.) It took me 19 years to reach financial freedom, investing more than 30% of my gross income. But, because TFSAs have been around since 2015 only, that portion of my portfolio is still small. I'll be withdrawing from my unit trusts and ETFS, and one day when I'm old enough, from the living annuity into which I'll convert my retirement funds. In such a scenario, paying either income tax or capital gains tax on withdrawals will be inevitable. It will be the same for you, if your TFSA hasn’t had plenty of time to grow.
Yes, it’s possible to retire tax free
The results of my calculations surprised even an optimist like me. YES, it’s possible to retire tax free in this country without needing to ship off your portfolio to a foreign tax haven.