This article was contributed to us by Sheng Shi Chiam, CFA, Personal Finance Lead at Endowus.
When it comes to the Supplementary Retirement Scheme (SRS), common questions most people would have are:
“At what tax bracket would it make sense for me to contribute to my SRS account?”
“At what age should I start contributing to my SRS account?”
“How do I maximise tax savings yet minimise future tax expenses when I withdraw from my SRS account?”
Tax rates and your age are known quantites, and investment returns can be modelled. So, answers to the above questions can actually be derived mathematically.
In this article, we’ll represent the questions as a math problem and find the most optimal solution, and then discuss trade-offs and decisions you need to make.
The Problem Sum
John is 35 years old this year, and he is earning a modest income that puts him inside the 7% tax bracket. He wants to maximise the tax savings by utilising his SRS account, putting in the maximum $15,300 for tax relief. He intends to withdraw his SRS account over 10 years past his retirement age. He thinks that he can make a 7% return on his investment.
Would topping up his SRS account now make him better off financially, assuming that the income tax rates will not change?
Tackling The Problem Sum: The Independent Variables
The above Problem Sum can be converted into the below formula:
J = ax+ by-cz
The independent variables, or the values x, y, z in the above formula, is fairly simple. These will be things like John’s
– Tax bracket
– 7% returns on investments
For the purpose of making this analysis simpler, we will assume that figures like the $15,300 committed in SRS, income tax rates are fixed numbers (or a, b, c in the above formula).
Defining the Answer – The Dependent Variable
The dependent variable, or the outcome that we are trying to model, is to see if John is better off topping up or not topping up the SRS account. To ensure that an apple to apple comparison is made, let us assume that John is only willing to commit $15,300 of pre-tax savings to invest.
Fleshing out the workings for the dependent variable:
Let H be 10-year yearly cash flow, net of taxes that John’s SRS account will give him when he withdraws his SRS monies while staying invested
Let I be 10-year yearly cashflow, that John’s post-tax cash account will give him.
H – I = J where J is the upside (or downside when the value is negative) from investing through SRS rather than using post-tax monies.
For H, Do note that since John would likely have put in a huge sum of money in SRS, and given that it compounds at 7%, his portfolio would have grown to $1.14 million by the time he is 62 years old. Even though only 50% of the amount withdrawn from the SRS account is taxable, the sheer size of John’s portfolio means that he will be taxed.
Remember that in the case that John paid his taxes, being in the 7% tax bracket, he would be left with $14,229 to invest in a portfolio that compounds at 7% return over the 26 years
When John is 62 years old, his SRS account will grow to $1.14 million. Net of income tax, John will have a yearly cashflow of around $159,000 liquidating his SRS account over 10 years.
If John were to invest using post-tax monies, John’s portfolio will grow to $1.06 million. John will have a yearly cashflow of $151,000 investing with post-tax monies.
John (or value J) is better off by $8,000 (rounded up) a year, just by investing through SRS instead of investing through post-tax monies.
Applying The Calculations To Your Own Situation
Of course, you are not John – your tax bracket is different, your age is different, your expectations of investment returns is also most likely different as well. To apply the principles to your unique situation, we can use sensitivity tables.
With a range of values for the independent variables, here are the situations when SRS can work for you, with red highlights being cases where it does not make financial sense for you:
John’s case (35-year-old, 7% tax bracket, 7% return) is highlighted in yellow above. As you can see from the above table, the higher your tax bracket, the more you save through SRS, even though you may be paying more taxes on an absolute basis.
Just like how a dollar now is worth more than a dollar in the future, a tax dollar saved now is worth more than a tax dollar paid in the future. This is because the tax savings can be compounded and grown to pay for higher taxes in the future.
Here’s how starting at different ages affects the upside that we can get from SRS:
However, the same does not apply for investment returns. The higher the assumed return on investment, the worse off you are.
The intuitive logic behind it is very simple. SRS account is a tax deferral scheme, so if you’re expecting a high investment return, it is better to be taxed now and then invest the rest, compared to investing now and be taxed later when your wealth has grown significantly.
Top Up Your SRS Account By 31 December 2019?
You might be tempted to save on taxes for 2019 by topping up your SRS account by the year’s end, but remember that SRS is ultimately a long-term commitment where your funds are locked in until retirement age.
Before you commit to topping up your SRS account, ensure you have sufficient liquidity to take care of your medium to long term large ticket expenses, such as buying a new property, or to fund your children’s tertiary education aspirations.
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