CPF SA vs SRS: Which is better?

LAST week, we discussed why the irreversible process of transferring Central Provident Fund (CPF) Ordinary Account (OA) monies to the Special Account (SA) might not be that good a deal.

For most people in their 30s and up, the gains from additional interest in the SA are arguably outweighed by how you cannot deploy those OA savings for property. To build up CPF SA monies, an alternative way is to top it up with fresh cash while enjoying tax savings.

Today, we explore a separate retirement savings method called the Supplementary Retirement Scheme (SRS).

We have written on the scheme in the past two years ("Not just Some Retirement Scheme", "How Supplementary Retirement Scheme works", Nov 24, 2014; "Can you start on the SRS too early?" Oct 26, 2015; "How to max out tax savings via SRS", Nov 23, 2015).

Like the CPF SA top-up, the SRS can give you tax deductions. But what is it exactly? Comparing the two, which one is better?

We conclude that the CPF SA comes out ahead, but only if you are willing to tolerate the lock-up period on your cash.

What is the SRS?

The SRS is a government scheme operated by the three local banks. It is a tax-deferred savings and investment plan. These schemes are common in countries such as the US and Canada. The idea is for you to enjoy tax savings when you contribute money into the scheme, as whatever you contribute will be exempt from tax now.

In the SRS, each dollar you contribute reduces your taxable income in the year by the amount contributed, up to a cap of S$15,300 for Singaporeans. So the first benefit is up front in the form of lower taxes.

Meanwhile, whatever you contribute to the SRS can be invested in local stocks, funds, bonds, and some insurance products.

When you retire, and need the income to supplement your CPF Life annuity, you can begin withdrawals from the scheme. You are still liable for taxes on whatever you eventually take out. This is why the scheme is a "tax-deferred" one.

Withdrawals are treated as income. Withdrawals before the statutory retirement age at the time of your first contribution, currently at 62, will also have a 5 per cent penalty.

But if you use the SRS the "proper way", and withdraw money only after you stop working in your 60s, you are not likely to pay much tax.

Advantages of the SRS

What is important to note for the SRS is how it is primarily a retirement savings vehicle - which just happens to offer you the flexibility to invest the money before you withdraw it many years down the road. The SRS is not primarily an investment plan.

It has two unique characteristics that are meant to entice people to participate.

First, you are only liable to pay taxes on half the amount you withdraw upon retirement age.

Second, upon retirement age, you can space out your withdrawals over a maximum of 10 years, further reducing what you are likely to pay under Singapore's progressive tax system.

These two features combine effectively with the progressive tax system here.

Singapore's tax system is such that if you have little income, you pay minimal tax. The first S$20,000 of income is tax-free.

Because half of what is withdrawn from the SRS is not taxable, retirees can withdraw up to S$40,000 a year tax-free.

Withdrawals, once begun in retirement age, have to be completed within 10 years. Thus a retiree with no other income can have S$400,000 in the SRS and still enjoy tax-free withdrawals provided they are spread out over those 10 years.

If you can claim other tax reliefs from the authorities, you are likely to enjoy tax-free withdrawals on an even larger amount. The additional amount is the relevant tax relief, times two.

For example, if you stay with a dependant parent, you can claim S$9,000 per parent. This means that if you are claiming for one dependant parent, you can withdraw S$40,000 + (S$9,000 x 2) = S$58,000 tax-free every year.

We multiply the relief by two because only half of what you withdraw, S$29,000 in the above case, is subject to tax. After claiming S$9,000 of tax reliefs, you hit the tax-free S$20,000 figure.

So it is possible to have S$500,000 in your SRS and still enjoy tax-free withdrawals over 10 years.

This is an amount that only people who start contributing early, or enjoy decent investment success, will be able to accumulate.

Disadvantages of the SRS

Talk of investment success, and we come to a disadvantage of the SRS known as the "implicit capital gains tax problem".

Admittedly, this is a "happy problem". If you start contributing in your early 20s and become extraordinarily successful in picking undervalued stocks to invest in with your SRS money, it is possible to end up with more than a million in the account by the time you hit withdrawal age.

You will then end up effectively getting taxed quite a bit on the capital gains and dividends you received. Whatever you withdraw is treated as income, and with such a large amount, you are likely to be taxed. If you had invested the money outside of the SRS, you wouldn't be taxed at all.

This might not be a big deal, as discussed in previous columns.

The tax rate you eventually end up paying is still likely to be small percentage-wise given Singapore's low tax regime and your ability to spread withdrawals over 10 years.

Investment success might come as the early withdrawal penalty is a psychological deterrent against trading rashly.

Another related issue is the "implicit estate tax" problem. Singapore does not have an estate tax. But if you kick the bucket while having a large amount of money in the SRS, the balances form part of your estate. Half of that sum is subject to income tax. You can't spread it out over many years. It will be taxed at one go. Your beneficiary is unlikely to complain, though.

Another issue might occur when prices have risen substantially by the time you retire, but tax policy has not caught up. For example, your ideal standard of living might be achieved by withdrawing S$40,000 a year tax-free from the SRS today.

Half a century later, maybe the same standard of living that you need to have costs S$100,000 a year, such that you want to withdraw more from the SRS. But to do so, you might have to pay more taxes on withdrawals. Hopefully, by then, the income bracket for tax-free withdrawals would have risen to match inflation.

How much should you put in the SRS, then?

The question is tricky because it depends on what your estimate of inflation is, and whether you have other retirement savings plans.

If you don't like the fact that your capital gains and dividends will potentially be taxed by investing through the SRS, don't put too much in it. You can stop contributing to it or actively managing the account once you are around the S$400,000 mark needed for 10-year tax-free withdrawals. Or don't invest the money and merely use it as unemployment insurance, as explained later.

If you think there will be some inflation, as seems likely, then you can aim to have more than S$400,000 in the account by the time you retire.

As tax brackets adjust to incomes, you are likely to be able to withdraw most of your money tax-free still.

What is more important is that the SRS should not be used to gamble in overpriced stocks or companies with dodgy balance sheets.

Finally, the biggest threat to the viability of the SRS is rising taxes. If taxes are far higher in the future than today, such that even the first S$20,000 of income earned will be taxed, then SRS savers will be up in arms. Their tax savings now will be meaningless. One has to hope this situation will never come to pass.

Key differences

With two separate schemes which one can enjoy tax savings from, you might ask which one is preferable: contributing cash to the CPF SA, or to the SRS. Both, after all, are very long term investment and savings vehicles.

Tax reliefs are limited to S$7,000 a year in the SA and S$15,300 a year in the SRS.

But the SA offers a far better rate of return when you adjust for risk.

It currently returns the current floor of 4 per cent a year. By contrast, cash left in the SRS merely earns the bank deposit rate, which is currently a paltry 0.05 per cent.

Not only do you enjoy a better rate in the SA, you can withdraw the money earlier.

At age 55, once you set aside the relevant retirement sum, you can withdraw the excess from the SA.

Whether you will have an excess amount of money in the SA by then, of course, depends on whether you can build up a sufficiently large sum earlier on. If you can, the snowballing effect is likely to cause your SA to compound beyond the inflation-adjusted minimum retirement sum by the time you hit 55.

So if you don't plan to withdraw the money anyway till you are in your 50s or 60s, the SA is better.

Either way, after you hit the full retirement sum cap on CPF SA, currently at S$161,000, you will not be able to contribute more into it.

Investors who want more flexibility, however, might prefer the SRS. Money in the SRS is not locked up. You can actually withdraw it at any time, though you face an onerous 5 per cent penalty.

Nevertheless, should you need the money to survive in an emergency before you hit retirement age, the 5 per cent penalty will still be worth paying - provided you contribute to the SRS from a marginal tax bracket of 7 per cent and above.

If you are comfortably in the 7 per cent bracket, making say S$70,000 a year and up, you will still come out ahead if you suddenly become unemployed and need some SRS money.

You can withdraw S$20,000 as tax-free "income" a year and pay the 5 per cent penalty. The penalty will still be lower than the tax you saved from contributing from the 7 per cent marginal income tax bracket.

In fact, you can even withdraw up to S$45,000 a year. At that amount, your effective tax rate will be 2 per cent. Combined with the 5 per cent penalty, you would have broken even on your participation in the SRS.

If you can claim tax reliefs, you will be able to withdraw even more.

However, the 5 per cent penalty will not be worth paying if you are already working, haven't turned 62, and plan to use the money to, say, buy a property. This is because withdrawals will bump you up to even higher tax brackets. It does not make sense to pay taxes from a marginal tax bracket higher than what you contributed into the scheme.

Hence the SRS can be used as an "unemployment insurance" account, where you contribute some money every year to guard against the scenario of having no income in your 40s or 50s.

Retirement first, investment second

Ultimately, to make sense of both the SRS and CPF SA, one should treat them as retirement schemes first and investment schemes second.

The retirement imperative - the idea of saving money in your youth to be withdrawn after you retire - should outweigh the investment imperative of making a quick buck.

You are likely to be satisfied only if you contribute to these schemes with retirement in mind.

When comparing the SA with the SRS, the main thing to note is that the SA lets you take less risk with your money for guaranteed returns. The tradeoff is that you cannot touch the money till you are 55 and have met the requisite retirement sums then.

By contrast, the SRS is not likely to yield much other than the initial tax savings.

You have to take risks with that money to grow it. For the SRS, achieving a consistent 4 per cent a year, which is what you get in the CPF SA, is a tough hurdle to beat.

So what should a young person do? From the standpoint of saving for retirement, you can first put S$7,000 in the SA every year until the account is maxed out. I wouldn't invest SA money, but if you want to, there will be schemes such as the upcoming Lifetime Retirement Investment Scheme and the existing CPF Investment Scheme for you to do so.

Then, if you have spare cash, put some money in the SRS, with the intention of guarding against periods of unemployment.

After building up a temporary "unemployment cash fund", the rest of the money in the SRS should be put to work prudently.

To get more yield, at a higher risk, it is best to stick the money in low-cost exchange-traded funds (ETFs). You can use SRS funds to buy ETFs listed on the Singapore Exchange.

If you want to partake in the risky business of stock-picking, one place to start is the strongest real estate investment trusts backed by the Temasek-linked names.

Personally, I've put a portion of my SRS money in a couple of cyclical stocks with strong balance sheets. They are trading at depressed valuations now, but will hopefully pick up when the global economy gets better. But much of my SRS is in cash, to be deployed in a bigger downturn.

To sum up, there are a number of strategies through government vehicles to save for retirement or get higher yields. The guiding principle to remember is to be conservative and avoid over-reaching for yield or high returns.

First, you can transfer your CPF OA to the SA. But as I am still saving for my first property, I prefer not to do so.

However, the SA offers a decent interest rate. I will use my cash to top it up first, and enjoy tax savings. Some cash will then go into the SRS for more tax savings. Some SRS monies will be invested.

The SRS is ultimately "supplementary". It is meant to complement the CPF OA and SA, not replace them.

It is nice to have. But you should only put in cash you don't need.

How much should you put in the SRS?

WHEN figuring out how much you should put into the Supplementary Retirement Scheme (SRS), have an idea of how much you need from the scheme first.

Then figure out how many years you want to contribute to it. To maximise tax savings, you should contribute while you are working. For most people, this period spans between 10 and 35 years.

There is no age limit for contributions to the SRS.

But if you have hit the statutory retirement age fixed at the time of your first contribution, currently at 62, and have started withdrawing, you can no longer contribute.

After figuring out how many years you plan to contribute, use the table as a guide for how much you need to contribute a year, assuming a yield of 0, 2 or 4 per cent.

If you are in your 40s and just want a bit of spending money when you are not working, say S$150,000, you need to put in S$6,200 a year for 20 years, assuming a 2 per cent yield.

By contributing S$6,200 a year from an 11.5 per cent tax bracket, you can save S$713 of taxes a year. If you aspire to hit the S$400,000 target for tax-free withdrawals of S$40,000 a year over 10 years, assuming no other income, you have to start contributing earlier.

If you are in your early 30s, you can hit the target by contributing S$13,400 a year, even if you do not make any returns on the money.

Finally, those who just entered the workforce, with a 35-year contribution period, can aim for even larger sums at the time of withdrawal.

If you can claim tax reliefs for supporting children or parents in your 60s, you will pay very little in taxes even if you have S$600,000 or more in your SRS account to withdraw over the maximum 10-year period.

The gist here is if you are in your 30s or older with still a bit of time in your career ahead, and you want to contribute to the SRS, feel free to contribute up to the maximum of S$15,300 a year with little fear of having to pay significant taxes upon withdrawal.

You might only get taxed a bit more if you make at least a consistent 4 per cent return over 30 years.

Given current market conditions, a 4 per cent yield will be an impressive feat, which essentially doubles what you have put in.

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This article was first published on September 19, 2016.
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