How does Tax Deferral help in financial planning?
A tax deferral scheme will benefit you if it makes better sense for you to pay tax on your income later and in the case of SRS, from age 62 onwards. The logic is simple – you are expected to be at a lower tax bracket from age 62 onwards as you stop working and with the 50% tax concession, you are essentially getting a discount on what you need to pay.
However, there are other considerations that will impact how well SRS can work for you besides the advantage of tax deferral or immediate tax relief.
Read on to see if the following applies to your personal situation before making a decision.
3 Financial Planning Checkpoints for SRS Suitability
1. You enter the “Golden Period” of Financial Planning (You have spare cash)
While it’s definitely better to start early when it comes to retirement planning, it can actually be too early when it comes to SRS contributions. This is because there is a penalty for early withdrawal before the age of 62 and the amount you withdraw is fully subjected to tax.
If you start contributing when you start work in your early 20s, you have to be prepared to set aside the money for almost 40 years. For some people, this can be too long to lock the money aside especially when all the major ticket items such as marriage, house and kids have not yet happened.
A good time to seriously consider SRS is when you enter the “Golden Period” of financial planning. That is the period when your standard of living starts to settle down and you are at the peak of your income earning. For most people, it should be sometime in their late 30s to early 40s.
This is the time when luxuries suddenly seem affordable, you start to tell yourself “if not now then when” when it comes to buying things and also most probably, you start feeling uncomfortable about your income tax situation which brings me to my next point…
2. You feel that you are paying too much in income tax now
Financial planners are not tax consultants but because retirement planning is one of the services that we provide to our clients, SRS and tax benefits often become a discussion topic.
All of us pay according to the same income tax table and the way the income tax rates are set (i.e. progressive rates), it is actually a good thing to be paying more in income tax than your neighbor who is paying less than you. This means that you are making more money and that is a good thing, at least when it comes to financial planning.
The “GST” Rule of Income Tax (This paragraph involves math, you may skip if you don’t like numbers)
There is a saying that “A big house to one is a garden shed to another” and how much income tax is too much is really a subjective matter that should be up to an individual to decide. For me personally, I use the “GST” rule. For the first $120,000 of chargeable income, the gross tax payable is $7,950. This works out to be 6.625% (or less than GST of 7%) which personally for me is a percentage I’m happy contributing.
On the other hand, for the next $40,000 of chargeable income (i.e. income from $120,001 to $160,000), the gross tax payable is $6,000 or 15%. This is “double GST” and also the trigger point for me to consider tax deferral schemes like SRS.
Thus, the key here is “feel”. If you feel that the tax you are paying is too much and you would like to plan for retirement at the same time, SRS will be a good way for you to kill two birds with one stone, presuming you don’t have too much taxable income in retirement which brings me to the next point…
3. You have little or no taxable income after age 62
I was once asked by a client how he can reduce the amount of tax that he is paying. My cheeky answer is that he can either reduce the income he is earning or have income that is not taxable.
SRS may be unsuitable when you have set up your retirement in such a way that most of your retirement income is taxable income. For example, if you continue to work into your 70s and have rental income from your investment properties (both these sources of income are taxable). Add in SRS withdrawals (even with the 50% tax concession), you may end up paying more tax on your SRS withdrawals than you have expected or planned for.
The key is to use SRS as part of your total retirement planning strategy and not as a standalone a-la-carte retirement plan. A good start will be to refer to the IRAS website on what is taxable and non-taxable income.
The theory of relativity of money (This paragraph involves a passing reference to science, you may skip if Einstein is not your cup of tea)
I’m not talking about time value of money. I’m talking about the same amount of money being valued very differently at different stages of life. For example, I’m currently staying in a condo and I have to pay $300 a month on monthly service fees. A retiree stays in the same condo and pays $300 a month on monthly service fees. The condo is the same, the amount is the same but the feeling can be very different.
The $300 feels like $100 a month to me while it could feels like $3,000 a month to him.
This is because I’m in my 30s, earning a good income and can see myself working for the next 20 years. For the retiree, he is in his 60s, no longer having a regular income and is wondering whether his exisiting retirement funds can last him for the next 20 years.
Understanding the relativity of money is important because while we will most likely pay less income tax in retirement (in absolute value), every tax dollar paid in retirement may seem much higher (and painful) relatively speaking. Ideally, we should plan to pay no income tax in retirement.