How Supplementary Retirement Scheme works

SINGAPORE'S Supplementary Retirement Scheme (SRS) is what is known as a tax-deferred savings plan. These plans are common in countries like the US and Canada. Essentially, participants are enticed to put money in them by the carrot of tax deferment.

Substantial savings will result if their tax rates in the future are lower than their tax rates currently. This is plausible, because when people retire decades later, they are earning less, or are not earning anything at all.

The SRS is even more attractive than that, which we will explain later.

But before that, let us consider a couple of scenarios.

Scenario 1: Marginal tax bracket is the same upon withdrawal

This year, you are 32 years old, and your marginal tax rate on income is 10 per cent.

You can save S$10,000 out of your pre-tax income this year. You are planning to invest the sum at a compounded rate of 5 per cent a year, in an investment where dividends or capital gains are not further taxed. You don't save any more for the rest of your life.

Let's say you do not use any tax-deferment savings and investment plan. You are charged the 10 per cent income tax out of S$10,000, and end up with S$9,000. You then invest it.

How much will this investment be when you are 62? It will be the post-tax amount compounded at 5 per cent a year for 30 years: S$10,000 * (0.9) * 1.05^30, or about S$38,900.

What if you put the sum in a vanilla tax-deferred savings plan?

You start out with a higher amount, because the sum is not taxed. But at the end of the period, because your marginal tax rate remains the same, you are no better off than if you had not used the plan.

This is because your money at age 62 would be: S$10,000 * 1.05^30 * (0.9). The tax just gets moved from the beginning to the end, and mathematically, the end-result is the same.

At age 62, your money had grown to S$10,000 * 1.05^30, or S$43,220. But being taxed 10 per cent takes you back to S$38,900.

So if you are in the same marginal tax bracket when you withdraw the money, there is no advantage or disadvantage in using a vanilla tax-deferred savings plan.

In fact, since the sum has compounded over time, you run the risk of ending up in a higher tax bracket if you can only withdraw the money as a lump sum.

Remember that whatever you withdraw is still taxed as income.

Scenario 2: Marginal tax bracket is lower upon withdrawal

However, for most people, they will be in a lower marginal tax bracket when they withdraw the money. This is the most common way which tax-deferred savings plans are supposed to work.

While you are working and in a higher tax bracket, you put aside some money which would otherwise be invested anyway. You only withdraw it when you are not drawing any other income.

Using Singapore tax rates as an example, let's say your marginal tax rate is in the 11.5 per cent range, meaning your chargeable income is between S$80,000 and S$120,000 a year.

And like the previous scenario, we assume a 32-year-old who puts aside S$10,000 and invests the money at a compounded 5 per cent yield, to be withdrawn 30 years later.

Without a tax-deferred savings plan, the S$10,000 of income set aside for the investment will become S$8,850 post-tax.

After compounding for 30 years at a 5 per cent interest rate, this works out to S$38,250.

By contrast, if you put S$10,000 in a vanilla tax-deferred savings plan, you would not be immediately taxed on that sum. Left to compound for 30 years, S$10,000 turns into S$43,220.

At age 62, you retire and stop drawing an income. Let's say you take out the entire amount at one go, and have no other income that year. Your taxable income for that year is thus S$43,220.

The first S$40,000 attracts just S$550 of tax, according to Singapore personal income tax rules. The remaining S$3,220 gets taxed at 7 per cent, which is S$225.

You thus pay S$775 of tax (an effective annual tax rate of 1.8 per cent) and end up with S$42,444 - some S$4,200 more.

Mathematically, your gain is your old marginal tax rate minus your new effective average tax rate, multiplied by your original amount and compounded over the relevant time period.

Scenario 3: Carrots and stick

In Singapore's case, up to S$12,750 a year can be placed in the SRS if you are a Singaporean.

The limit is there to prevent high-income or asset-rich individuals from treating the scheme like a tax haven and thus gain an undue tax advantage.

Compared to the traditional tax-deferred savings plan that we have discussed, the SRS offers two additional carrots and one stick.

The two carrots are:

The stick is:

In our previous example, the S$43,220 that has been accumulated in the account might not even attract any tax if a retiree withdraws the sum after age 62.

This is because in Singapore, the first S$20,000 of income is tax-free.

And because half of what is withdrawn is not taxable, a retiree not earning any other taxable income can withdraw up to S$40,000 a year tax-free.

This means if he spreads out his withdrawals over two years, he need not pay any tax.

His total gain is thus his marginal tax rate at the time of contribution, multiplied by the contribution amount, and compounded over the time period: S$1,150 * 1.05^30 in this case, or almost S$5,000.

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