When it comes to investing, tax is the silent killer of returns. Ignore it, and you’ll see years of careful saving eroded away. Optimise it, and you can add millions to your retirement pot. In South Africa, two vehicles stand out: the Tax-Free investment and the Retirement Annuity (RA). Both are powerful. Both have traps. The smart money knows when to use which.

The tax-free investment: Freedom and flexibility

The tax-free account is beautifully simple: invest, let it grow, withdraw whenever you like, and pay no tax on the growth, ever. Dividends, capital gains, interest – all of it is yours, tax free.

That freedom comes with strict limits. You can only contribute R46,000 a year, capped at R500,000 over your lifetime. Exceed it and SARS will levy a 40% penalty on the excess. Critically, withdrawals cannot be replaced; once money comes out, that lifetime contribution allowance is gone forever.

Still, the upside is massive, and growth is uncapped. Your investment options are extensive too. Don’t fall into the trap of putting your tax-free savings into a fixed interest account at a bank. You can, if you want, invest 100% in offshore equities for example (unlike an RA), chase higher long-term growth, and keep fees very low if you invest wisely. There are no annuity rules and no strings attached. It is pure, untaxed compounding.

The RA: Disciplined growth with a powerful payoff

The RA is a different beast: it rewards you upfront. Your contributions are tax-deductible, reducing your taxable income today. A high-income earner in the top tax bracket, for example, can get an immediate R45 back from SARS for every R100 they invest into an RA.

But the taxman always collects, right? Mostly, but not completely. RAs do have some handcuffs. First, your money is locked up until age 55. Since September 2024, a third of your contributions go into a savings pot, from which you can make one withdrawal a year. However, these withdrawals are taxed at your marginal income tax rate. Secondly, Regulation 28 limits how your RA is invested. With lower offshore and equity exposure you are potentially sacrificing higher long-term returns. Finally, the funds available for an RA tend to have significantly higher fees than the passive high-equity ETFs that you can access through a tax-free account partly as a result of the extra management and administration costs.

But RAs come with a happy ending. When you retire, you can take up to one-third of your RA as a cash lump sum, with the first R550,000 of this being completely tax-free. The remaining two-thirds must buy an annuity, and it’s this income stream that gets taxed. That upfront tax break, plus a good tax-free payout at the end, is a formidable combination.

Furthermore, RAs are shielded from creditors, and they fall outside your estate, meaning your heirs pay no estate duty on the funds (contributions made since March 2015 that were never deducted for tax are added back to the estate for estate duty. For most this is a minor point.). A tax-free account, by contrast, forms part of your estate.

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Which is better? The Rule of 45

The right strategy depends entirely on your personal circumstances, but let’s assume you plan to start drawing down on your retirement funds after you turn 65. Here’s a simple rule you can follow to allocate your retirement savings (I call it the “Rule of 45”):

• If you’re under 45 years old, or paying less than 45% income tax, prioritise contributing to your tax-free account. The RA’s tax deduction isn’t worth as much if you’re paying tax in the lower tax brackets. The tax-free investments unrestricted investment choice, lower fees, and tax-free withdrawals will likely deliver a better outcome over a long period of time and you have decades before you plan to draw down.
•  If you’re closer to retirement and a high-income earner, the picture changes. The tax refund from your RA contribution is too good to ignore when you’re in a high tax bracket. With less time before you start drawing down from your investments, the difference in fees and returns between the tax-free account and RA are also less impactful. That said, if you’re a high-income earner and only just starting to invest for retirement you should be squeezing everything you can into retirement savings and should be able to afford R3,833/month into a tax-free account on top of your RA contributions.

The only reliable way to evaluate the right mix is to crunch the numbers. You need to take into account your current tax rate, the rate you’ll pay on drawdowns in future, how much you can get out of your RA as a tax-free lump sum, the expected return on a high-equity ETF in your tax-free account vs a Regulation 28 compliant fund in your RA, and most importantly the amount of time you have before retirement.

If creditor protection or other features of the RA are important to you (e.g. you’re an entrepreneur or self-employed) then these need to be considered as well.

The ultimate strategy

In our analysis, we’ve found that for the vast majority of people the logic is simple:

1. Max out your tax-free account first (R3,833 per month). This builds a flexible, tax-free pot of money you can access anytime, which is invaluable.
2. Then, contribute as much as possible to your RA. This enforces saving discipline, provides creditor and estate protection, and delivers a powerful tax deduction.

For example, if you can afford to put away R5,000 for retirement each month, it’s likely that the best strategy is to put R3,833 into your tax-free investment, and the rest into a low-fee RA.

If you max out your tax-free account each year, you’ll hit your lifetime limit within eleven years. After that you can direct all your retirement savings to your RA. You’ll likely be earning more by then and be in a higher tax bracket. As a result, the portion of your savings going into the RA would have been increasing each year and you’ll be benefiting even more from the RA’s tax savings than if you had over-contributed too early.

Optimised drawdowns to minimise tax

In retirement, these two vehicles work in perfect harmony. You can draw a modest income from your annuity to stay in a low tax bracket and then supplement it with tax-free withdrawals from your tax-free investment. This gives you ultimate control over your retirement income and your tax bill.

Tax efficiency isn’t a nice-to-have. It’s the difference between scraping by and living comfortably. The smart play isn’t tax-free account or RA. It’s knowing how they work together to build you a stronger financial future.

Adrian Hope-Bailie, CEO, Fynbos Money

Saving for retirement is the biggest investment most of us will ever make. Sadly, it can also be very complicated. In this monthly blog, Carina Jooste responds to common retirement questions, ranging from which products are best suited to different circumstances to efficient tax treatments.