Can you start on the SRS too early?

IT is that time of the year again, when all three local banks might roll out promotions to urge Singapore workers to contribute to their Supplementary Retirement scheme (SRS) accounts, operated by them.

The SRS, if you haven't heard of it already, is a neat tax-deferred retirement savings scheme that has been steadily gaining popularity but is still relatively unknown.

You don't pay tax on whatever you put in now. This means that if you have a high marginal tax rate, you get a hefty tax deduction when you contribute to the SRS.

Another incentive is that half of what you withdraw at retirement is also tax-free. The other half is taxed as personal income. You can spread out withdrawals over many years to further lower your taxes.

You benefit from the SRS due to Singapore's relatively low tax rates, especially for lower income brackets.

You can hit the retirement age of 62 with S$400,000 in your SRS account and withdraw the entire amount tax-free, provided you spread out your withdrawals evenly over the maximum 10 years allowed and are no longer drawing any income. Only half the S$40,000 a year you withdraw is taxable, and the first S$20,000 of income is not taxed in Singapore.

Theoretically, all 1.6 million taxpayers in Singapore stand to benefit from tax savings as a result of contributing to the SRS.

However, those comfortably in the 7 per cent marginal tax bracket and up are more likely to see tangible benefits, and thus more likely to sign up.

This means people earning a chargeable income of S$50,000 a year and more. There are 600,000 such people, based on latest tax data.

If they contribute the full amount, which is S$12,750 this year and S$15,300 from 2016 onwards, they will see tax savings of S$1,000 to more than S$2,000 a year for higher income earners.

Participation in the scheme has been increasing at respectable double-digit percentage rates.

Yet as of end-2014, only just over 100,000 people are in the scheme.

That means there are hundreds of thousands of people who can benefit from the scheme but are not yet participating.

For some people, saving a couple thousand dollars a year might not matter compared to the inconvenience of having to pay an early withdrawal penalty should they need the money before their twilight years.

But for those willing to treat the SRS as a very long-term savings account or rainy day fund, the scheme has its advantages that can even outweigh the early withdrawal penalty, as we discuss later.

Foreigners can also benefit from the SRS due to a higher contribution cap and an ability to make a penalty-free lump sum withdrawal after 10 years.

However, these advantages are mitigated by a withholding tax deducted upon withdrawal, and the lack of tax reliefs on Central Provident Fund (CPF) contributions that locals enjoy.

Foreigners will also pay a higher tax upon withdrawal if they are no longer living and working in Singapore.

Who should contribute?

Before contributing to the SRS, you have to think about whether it fits your needs.

The most important need filled is that of an additional pot of money for you to spend in your retirement, which you might not be saving otherwise for.

However, you should only contribute to it after taking care of more urgent personal finance needs, notably credit card and personal debt.

Another use for the scheme is to build a rainy day fund for a time when you find yourself unemployed or having to stop work.

Here, the SRS is akin to a bank account, but with a catch.

You can withdraw money from it any time. But you are hit with a 5 per cent early withdrawal penalty should you withdraw money before the retirement age, currently at 62.

After you hit that retirement age, you can withdraw however much you want penalty-free. What you withdraw will be regarded as part of personal income that year, subject to tax the following year.

The age at which you can withdraw the money penalty-free is fixed at the statutory retirement age at the time of your first contribution.

Given that this age is likely to go up over time with longer lifespans, the young should make a contribution as soon as they can to "lock in" their SRS withdrawal age, if they think they find the SRS useful.

This gives them more flexibility to withdraw their money in the future.

Even if you have to withdraw money and pay the 5 per cent penalty before your retirement age, you can still benefit.

This is if you have contributed money from a higher marginal tax bracket, say 7 per cent or 11.5 per cent, and you can make a tax-free withdrawal of S$20,000 in a year where you have no income.

You are penalised 5 per cent for the early withdrawal, but you have already saved the 7 per cent or more of tax you otherwise had to pay. In fact, if you have made all your contributions from only the 7 per cent tax bracket, you can withdraw early, up to S$45,000 a year, and still come out unhurt.

This is because your effective tax rate at S$45,000 a year is 2 per cent. Together with the 5 per cent penalty, this adds up to 7 per cent, which is what you saved in the first place.

The higher your bracket, the more you can withdraw early and still come out ahead.

Contributing too early

Withdrawing early should be a last resort, nevertheless. The 5 per cent penalty still hurts.

The problem we examine today is the opposite one - having too much.

It is relevant to those who started contributing to the scheme at a relatively young age.

We know that the magic of compounding can dramatically increase one's returns over a long period of time. While you can leave your SRS money sitting in cash, you can put it to better use investing it.

Many more people are doing so.

While just 1 per cent of SRS portfolios were invested in stocks, real estate investment trusts and exchange-traded funds in 2001, this proportion has grown to 26 per cent by end-2014.

Meanwhile, the proportion of SRS money put in insurance has gone down from a high of 44 per cent in end-2002, to 22 per cent at end-2014. Last year, I made my first contribution to the SRS.

This year, I used that money to invest equally in two mid-cap stocks that I felt were undervalued.

Fortunately for me thus far, a recent market rebound meant each stock has gone up by 10 per cent from their initial purchase prices.

This throws up an interesting question.

A consistent 10 per cent rate of return a year is difficult to keep up over a long time horizon, and I am not expecting that to happen for me.

But let's practise some naive extrapolation. Suppose this streak continues throughout my life. Will I be penalising myself by using SRS money to invest in stocks?

And even if I just put the money in a broad index-tracking fund, historical returns suggest I will make 5-7 per cent a year if I stay in the market long enough.

The final sum I end up with can be huge.

It might then not be worth contributing to SRS.

My SRS investments will be taxed relatively heavily as personal income if I need to liquidate and withdraw them. If I want to transfer hugely appreciated shares to my Central Depositary (CDP) account, which I can only do after my retirement age, I will still be taxed on half their value.

If I did not contribute to the SRS and used my post-tax money to invest instead, I would not be thus implicitly taxed on the capital gains I made on my stocks.

This issue was hotly debated when the SRS first got introduced.

Tax-deferred schemes like the SRS do not work well for individuals if they end up in a higher tax bracket upon withdrawal from the scheme, compared to the tax bracket from which they contributed.

In its SRS booklet, the Ministry of Finance responded to the issue by pointing out that half of what is withdrawn is not taxed, and by spreading withdrawals out the individual can benefit.

Now that the SRS is gaining traction, and more people are using their SRS monies to buy stocks, this issue is worth examining again.

This problem is especially pertinent to the young investor, because there is more time for him or her to accumulate money in the SRS.

Older folk who started contributing to the SRS in their 50s do not need to worry.

Given a 10 per cent rate of return and consistent contributions, it still takes 14 years to hit the S$400,000 mark where they get to withdraw all their money tax-free over 10 years.

However, if someone started contributing at age 28, and made a 10 per cent rate of return over his lifetime, he would have S$4 million in his account by the end of the year when he hits the withdrawal age of 62.

Even if he spreads out that money over 10 years, he will still have paid S$220,000 in taxes by the end of it all.

In a sense, this is a 41 per cent tax on the S$530,000 he put into the SRS in cash and so cleverly managed to grow.

Moreover, this investor is also likely to be collecting rental income from property investments, so he will be paying quite a bit more in taxes due to his higher chargeable income.

As Singapore has no capital gains tax, he would have been better off investing outside of the confines of the SRS.

Not a big deal

The above scenario I painted is, however, not likely to occur to too many people.

One current way to get around the implicit capital gains tax problem is for the shrewd investor to park that S$4 million in a single-premium lifelong annuity upon retirement.

He will be taxed on half his annuity payout every year, but he won't have to pay large taxes immediately.

However, he might want to withdraw and invest the money himself.

Another way to get around this problem is thus for the government to lengthen the period which withdrawals can be made.

This way, people with large sums saved up in their SRS accounts can spread out their payouts over time to benefit from Singapore's progressive tax regime.

This allows for more flexibility for withdrawals.

In our bull case, our shrewd investor can withdraw his S$4 million over 30 years and enjoy a comfortable pre-tax income of S$130,000 a year.

Given the likely cost of things 50 years down the road, that income might not seem extravagant the way it is to most people now.

What is more likely is that the young investor will make a 5 per cent rate of return if he invests prudently and consistently.

In this case, is there still an implicit capital gains tax problem?

With a 5 per cent return, our young investor who starts contributing to the SRS at age 28 will end up with S$1.4 million upon retirement.

If he spreads out his withdrawals, he ends up paying S$25,000 of taxes in total, or an effective tax rate of 4.8 per cent on the S$530,000 he paid in cash over the years.

This is more palatable, and he is still likely to come out ahead.

And actually, even if you end up in the fortunate situation of having to pay a sizeable implicit capital gains tax, the tax is not that big to begin with.

Just compare it with the gains you have made, and with other capital gains tax regimes around the world.

For example, the UK can impose a capital gains tax of 18-28 per cent, and the US, 15 per cent.

Even in our bullish scenario, our shrewd investor is paying at most a 6 per cent "tax" on his capital gains, assuming he spreads out his withdrawals and has no other income.

And would you have invested your money outside the SRS the same way you invested your money within the SRS?

As mentioned in a previous column, the psychological deterrent of the early withdrawal penalty can work in my favour by nudging me not to buy and sell rashly.

Another psychological trick is to treat the account separately as a "last resort account" that you will tap to buy into blue chip stocks only when you have exhausted your cash.

Given that people are bad at timing the market, this mental accounting trick creates an additional margin of safety to invest only when prices are really depressed.

Thus I will still put in as much as I can into the SRS to optimise my tax benefits.

The plan, which I hope I can keep up, is to leave the SRS money in cash until periods of extreme fear.

Ultimately, you don't want to use your SRS money to buy overpriced or dodgy stocks.

The worst thing that can happen is if you invest recklessly, get burnt, and then you find that you really need the money and are forced to withdraw a destroyed capital base at an early withdrawal penalty.

If your money in the SRS really snowballs into millions, that is a happy problem that can be dealt with when you come to that bridge.

You can adjust your asset allocation and shift SRS money into bonds and fixed deposits. You can keep contributing to the SRS to build up your cash levels and enjoy tax benefits.

And you just use your post-tax money outside the SRS to invest in undervalued stocks that you have shown an ability to pick.

And if you think the government spends your tax money wisely, just go ahead and pay those taxes, which are small compared to what you would be paying in another country.

You can console yourself by saying you have contributed your fair share to nation building.

This article was first published on October 26, 2015.
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