There was an article by Larry Haverkamp on SRS in today’s Sunday Times which argued that SRS works best for the rich. While this is true, I would argue that SRS is beneficial for most people who pays taxes as long as cashflow and liquidity is not an issue.
If you can get an immediate 5% return just by contributing to SRS, why not?
Larry gave an example of a 22 years old man earning a taxable income of $100,000 with a $10,000 annual contribution.
By contributing to SRS, the person can save $1,400 in taxes every year. Over 40 years, this works out to be $56,000.
Assuming the SRS grows at 7% p.a., the SRS savings will grow to be almost $2mil (or $2,136,096) at the end of 40 years. If one withdraws $200,000 over the next 10 years, he needs to pay tax of $7100 per year. This works out to be a total of $71,000.
At first glance, it appears that the person has ended up paying more tax due to the good performance of his SRS account. As all the investment gains is being taxed, it might also seem that SRS imposes a capital gains tax and tax on dividends.
While this might be true indirectly, we should also bear in mind that $1000 tax paid today and $1000 tax paid 40 years later have a very different value.
Remember that all your deferred tax is generating compounded returns before it is taxed in the future.
The easiest way to illustrate using the above example is to see how much savings you would have after 40 years if you had not contributed to SRS and managed to grow it at 7% p.a.
Since you have to pay tax of $1400 every year, you can only save $8600 (compared to $10,000 if you had contributed to SRS). Compounded at 7% over 40 years, this works out to be $1,837,042, which is about $299,000 less than your SRS total return.
Put it another way, you can afford to pay almost $30,000 in tax every year during your SRS withdrawal and there would be no difference whether you contributed to SRS or not.
However, in the example where $7100 tax was paid each year during the SRS withdrawal years, the person would be very much ahead.
Due to the fact that half of the SRS withdrawal amount is not taxable, probably the only time a person can be worse off contributing to SRS is when his tax rate at retirement is twice that of his income generating years.