In recent years, the creation of passive income for the family has become one of the most talked about and important topics in the financial world.
In a world without guaranteed benefits, where each of us is responsible for our own destiny, the question is: how do we generate for ourselves passive income that is connected to our permanent work, to create income that is not dependent on us and in fact allows us in stages to move forward on two tracks at the same time (passive and active income).
The first track is in which we continue to work (perhaps in a partial format) and generate a passive supplementary income, but at the same time, we have an additional and permanent source of income every month.
What is Passive Income and Why Should it be Generated?
Passive income is usually defined as an influx of income paid out with little effort that is required of the individual receiving the passive income to increase his revenue stream. Examples of passive income can include income from the rental of a real estate property and any business activity in which the earnings owner does not participate materially during the year.
The IRS defines passive income as income from income sources that are not a “business or “occupation”, such as rental income, royalty income, dividend and interest, key fees, etc.
Examples of income that the Institute of National Insurance considers passive income are: dividends, directors’ salaries, income from abroad, interest, rents, and more.
Active income refers to an income stream where one is constantly required to remain active to maintain the income stream, such as wages and partnership income. The income from an investment portfolio is derived from investments and includes capital gains, interest, dividends, and royalties.
An End to the Welfare State and the Transition to an Accumulating Pension
In the past, in the old pension funds the peers accumulated two percent of their salary towards their pension each year, and the pension was calculated based on the peer’s salary near retirement or based on the salary during the period of work.
In the late 1980s and early 1990s following a period of longevity and a growing deficit of the pension funds that promised lifetime rights to the worker. During this period were enacted and a new law was implemented in which the citizens of the state will move from a world in which they pay for the purchase of lifetime benefits to a world in which they deposit money into accumulating funds towards the day they move from a life of work to a life of welfare.
The money accumulated in the funds is only to be released as a pension or a drawdown when the investor reaches retirement age.
What Do You Do With the Money You’ve Accumulated?
The regulator’s intention was to encourage saving by granting tax benefits and that the public would convert this money into a guaranteed income flow for life (an annuity) guaranteed by an insurance company or pension fund.
The key to conversion has changed over the years but decades ago insurance companies were very generous with the conversion rates and over the years the key has become less and less attractive.
How Does the Conversion Key Work?
In the 1980s and 1990s, insurance companies used mortality tables from the 1950s to calculate the coefficient of conversion. Since the average life expectancy in those years was lower than that of today, the coefficients in policies marketed at the time were particularly low.
Over the years, of course, mortality tables have been updated, and with them, the benefit coefficients: for example, insurance policies sold in the 1980s promised a conversion rate of 147 for a man reaching retirement age 65, while in the 1990s the conversion rate had already climbed to 167. In the 2000s, the conversion rate surged again until it reached 200 at the age of 67, thus adapting to modern life expectancy.
For example, an investor who has accumulated NIS 1,000,000 in his account, and was promised a conversion rate of 200, will receive a monthly allowance of NIS 5,000 for the rest of his life, based on the calculation: 1,000,000 /5,000 = 200. This means that with this conversion rate the investor will receive 6% of the money accumulated that is guaranteed for the rest of his life.
The agreement with the insurance company/pension fund is irreversible so that on the day the conversion is made the investor does not own an asset anymore and has replaced it with a guaranteed benefit provided by an insurance company or pension fund.
Is this Method Good for the Investor?
There are pros and cons to this. On the one hand, it is an income stream that is guaranteed for life and this is reassuring, but on the other hand, investors who have accumulated money throughout their lives gave up their assets in favor of receiving the promised revenue stream.
The alternative of course is any investment that yields 6% with the option to pay out the income created over the years, for example an investment in real estate that yields 6%. In this case the client will receive the same 6% throughout his life but in addition he will inherit the property in full.
The Tax Consideration
Many pensioners think that once retirees arrive at pension age social security and income tax payments end. For the first part, they’re right, after eligibility for a senior citizen’s allowance, you don’t pay tax on Social Security, but the ITA (Israel Tax Authority) keeps requiring tax on the pensions as if this was regular income.
In fact, in the eyes of the ITA, pensions are active income, not passive income, so you are required to pay a regular tax according to the tax levels minus your credit points.
Of course, about tax one should consult a professional as there are many opportunities and challenges, but the reality varies from person to person.
Investment Through a Provident Fund Under Personal Management in Amendment 190
Amendment 190 to the Income Tax Ordinance, which took effect in 2012 and addresses a variety of issues, including the provision of benefits when taxing benefits and capitalization. One of the advantages of the amendment is the possibility of depositing funds into a provident fund in an independent status and withdrawing the funds in one of the following two options:
Withdrawal of a monthly allowance – when the allowance will be tax-free for life.
Capitalization of a recognized allowance (one-time withdrawal) – subject to compliance with certain conditions and payment of tax at a rate of 15% nominal from the relative profit component, instead of a rate of 25% real tax from the profit component, as is customary in the market.
Who it suits:
Mainly for those with available funds close to the age of 60, who wish to find an excellent alternative to investment. In addition, Amendment 190 opens the possibility for high-income employees (more than twice the average wage) who wish to deposit long-term pension savings beyond the deposit ceiling that entitles tax benefits. Amendment 190 allows the funds to be withdrawn as a lump sum (by way of capitalizing on a recognized allowance) while utilizing tax benefits for colleagues who meet certain conditions.
An example of a comparison of an accumulation of NIS 10,000,000 (which allows an annuity of NIS 600,000 per year).
Basic assumptions: *Marginal tax of 40%, investment gains 10% per year. Inflation 0%.
In this case, the investor who chose an annuity will be taxed at NIS 240,000, and they will receive NIS 360,000 but in the event of death he will not be entitled to the initial fund.
In the event of a partial withdrawal of the peer fund, a reduced capital gains tax on the investment (15%) will pay a reduced capital gain tax on the investment (15%) if he has withdrawn NIS 600,000 per year he will pay about 10% (which is part of the profit)15% tax which is 19,000 NIS tax per year and the net will be NIS 549,000 per year (instead of NIS 360,000) and in the event of death, the entire invested fund will go to the heirs.