Sunday, April 13, 2014

Supplementary Retirement Scheme (SRS) and Income Tax

The Supplementary Retirement Scheme (SRS) is, I suppose, a Singaporean solution to the US' 401(k) or the UK's SIPP (not ISA which is taxed on entry and not exit, the opposite of a SIPP). It is a retirement account aimed to help grow savings by offering to waive tax off the voluntary contributions into the account, with the catch that you can only withdraw these funds with special tax treatments after a certain age.

The tax relief is dollar for dollar for every contribution made into your SRS, up to a pre-determined yearly limit (which is $12,500 now).

However, given that income taxes in Singapore are considered low by global standards and that the costs of living is expensive by global standards as well, there is a thin line between deferring current spending to save on taxes and have a larger retirement amount, versus contributing too much into these accounts that your current way of life is crippled and you may have no choice but to pre-maturely withdraw some of your SRS savings and get slapped with a higher tax! However, I will give my personal opinion regarding when and how much I think is the optimum amount to to be placed in the SRS.

I think it is extremely important to accurately forecast your expenses and ensure that the money going into your SRS is exclusively meant for your retirement needs after age 62. If there is a good chance that you need the money before then, do not put it in your SRS! The 5% early withdrawal penalty and the taxation over current income will definitely be an extra burden that you can do without. Only spare what you know you will really never need in a long time into this SRS account.

Singaporeans have no withholding taxes, well because, we are from Singapore! Since my brain is of limited space, I have exclusively decided to refrain from absorbing any information regarding SRS and foreigners, sorry people.

The last reference that I have is regarding the withdrawal of SRS funds and how they are treated tax-wise. The most important thing to know is that you are able to withdraw your funds over 10 years, so there is no need to withdraw it all in one shot. The benefit of withdrawing your funds periodically over these 10 years is also so that you can get the maximum benefit of the specialized tax treatments.

Optimally, your SRS account will only have $400,000 when you retire. This is because the most optimal annual withdrawal rate is $40,000 a year. Only 50% of the withdrawn income is subject to tax, meaning that $20,000 of your SRS withdrawal will be tax. Good news, income under $20,000 a year is NOT taxed. That means, $40,000 a year, tax-free!

My Personal Opinion

Please take note that this is just my personal opinion, and I am just pulling numbers out of a hat right now. I'm trying to use numbers so that I can make this easier to understand for everyone.

To optimize tax benefits, value at age 62 should be $400k. Let's be crazy. Let's assume no capital gains growth because no investments are made, and that this SRS account is just purely used as a tax deferred cash savings. To reach $400k, you would have to max out contributions for 32 years. If you're planning to work until 62, that means you have to start maxing out your SRS from age 30.

Now, assume you contribute the maximum limit of $12,500 and have a conservative 5% growth in your SRS account while you actively contribute. Using Excel and working backwards, your first year of maximum SRS contributions should be when you are 43 years old.

Now, what if you want to retire early? I would personally like to retire when I am 55. That means after age 55, there will be no more capital additions to the SRS account. The value of the account will then have to appreciate to $400,000 by the time I turn 62. Using Excel and working backwards, my first year of maximum SRS contributions should be when I am 39 years old.

Tax-deference only, no investments: Start maximum contribution at age 30
Work until 62, 5% returns: Start maximum contribution at age 43

Work until 55, 5% returns: Start maximum contribution at age 39

But what if nominal returns were 8% instead? The STI returns 5% capital gains and 3% dividends and their compounded effect can bring returns up to 9%. Assuming friction, what if we can get 8% returns then?

Work until 62, 8% returns: Start maximum contribution at age 46
Work until 55, 8% returns: Start maximum contribution at age 44

As you can see, the larger the expected compounded returns, the bigger the difference that starting investing early does. By starting just a mere 2 years earlier, that is equivalent to not having an extra 10 years of contributions. Therefore, probably the most optimum time to start contributing the maximum amount to your SRS account is around 40.

However, now the real question is, is it more cost effective (tax-wise) to occur capital gains in your SRS account and therefore make early contributions? Or is it more cost-effective defer SRS contributions until the optimal age and make cash investments instead?

To tackle this question, I will be fixing some parameters. Assume that a person only makes an investment of $12,000 a year. If it is going towards his SRS account, the entire sum will be invested tax free. If it is not invested in his SRS account, it will tax at the prevailing income bracket rate.

Calculating the total after-tax returns of investing $12,500 into your SRS account every year from age 25, you would get $2.65 million over the 10 years after age 62. If you were invest after-tax balance of the $12,500 until age 45, and started maximum SRS contributions at age 46, then the final amount to be received at age 62 over the next 10 years is dependent on the tax-rate.

If you are being taxed over 7%, it would make more sense to be invested with the SRS instead. However, the biggest difference is that $2.25mil will be always and immediately available for your usage when you are aged 62, with no restrictions. The $400k in the SRS account will slowly be paid over 10 years.

Therefore, considering the fact that the SRS account is locked and frozen until you're 62 to withdraw without penalty and with preferred tax treatments, it is only a small price to pay in the final ending value to be able to have the flexibility and the ability to be able to use your investments whenever you want.

In conclusion, unless you are really very very very rich (no need to worry about meeting liabilities), it is not advantageous to lock up your money in your SRS account for the preferential tax treatment instead of doing cash investments. In the most extreme case scenario, if you are being taxed in the 20% bracket from age 25, you are only losing 15% to have this benefit. If you are in the 11.5% bracket, you are only losing 6% for the flexibility. However, realistically since most people are not in the 11.5% bracket in their early 25s, there is no practical benefit from starting very early to fund your SRS account. The SRS account should be ideally aimed to be withdrawn at age 62 at the optimum $400,000 amount.

PS. *Do note that the lower the expected compounded returns, the larger the difference between the accounts and the more it makes sense to be tax deferred. Therefore, if returns are expected to be good, do not contribute to SRS. If they are expected to be low, SRS contributions makes a larger difference.

1 comment:

Observe the house rules.