Retirement Benefits from Retirement Funds
13 June 2011
By Matthew Lester, Professor of Taxation Studies at Rhodes University, Grahamstown
The government policy is ‘partial taxation of the withdrawal benefit.’ Taxation is not imposed on withdrawal willy-nilly. There is a wide range of procedures to legitimately minimise or control the incidence of tax on withdrawal benefits.
There are also various misconceptions relating to the taxation of retirement fund withdrawal benefits. In addition, many relate to the approaches we undertook vis a vis retirement planning prior to substantial amendment to the second schedule of the Income Tax Act. Then add to the pot a variety of changes over the past 10 years that have been largely ignored.
The Way We Were
Commence with retirement planning as it was 20 years ago:
- Taxpayers’ contributions were tax deductible (no change).
- The growth within the fund was tax free (No change there either).
- Withdrawal by way of annuity income was expensive due to the very narrow income bands within the personal tax tables. The personal tax tables quickly escalated to a marginal rate of tax of greater than 30%.
- The tax exemptions relating to lump sum benefits contained in the second schedule of the Income Tax Act were considered generous.
- The taxable portion of lump sum benefits was subject to the ‘averaging concession.’ And there were a variety of ways to manage the average rate on retirement.
- Medical aid benefits were continued by the employer post retirement, often at full cost to the employer.
- There was widespread fear that a new Government would seek to access wealth in retirement funds as a way to fund the new RSA, either through taxation or prescribed investment. This acted as an incentive to exit retirement funds.
- Interest rates ranged between 12 and 22% per annum, thus there was no incentive for the investor to take on risk.
The above retirement strategies were essentially driven by the following rules of thumb:
- Leave as little as possible within the fund to be subject to tax on withdrawal at a high marginal rate.
- Exploit the second schedule to obtain the maximum tax-free lump sum withdrawal benefit.
- Maximise the loopholes within the averaging formula.
- Invest the after-tax lump sum withdrawal benefits in the money market using up the lower marginal rates of tax and the annual tax-free interest concession.
- If necessary, use insurance policies to contain taxation at a maximum rate of 30%.
The Way We Are
Now consider the extent of change over the past 20 years:
- The ‘Trevor Manuel era’ was committed to building a better deal for the individual taxpayer.
- Tax thresholds (i.e. the level at which one commences actually paying tax) have been increased for the 2012 year of assessment to:
- Under 65 years old - R59 750
- Over 65 years old - R93 150
- Over 75 years old - R104 261
- The interest free abatement has been increased to:
- Under 65 years old - R22 800
- Over 65 years old - R33 000
- Thus the true tax threshold for a pensioner today is actually:
- Under 65 years old (R59 750 + R22 800) = R82 250 or R6 854 per month
- Over 65 years old (R93150 + R33 000) = R116 980 or R9 665 per month
- Over 75 years old (R104 261 + R33 000) = R136 261 or R11 355 per month
- Now apply an inflation rate of 6% and a growth rate of 14% (a very optimistic outlook) and calculate the capital required to yield an income stream equivalent to the tax threshold for a taxpayer retiring at 60 today.
- Under 65 years old (R59 750 + R22 800) = R82 250 or R6 854 per month for 5 years, today = +/- R337 000
- Over 65 years old (R93150 + R33 000) = R116 980 or R9 665 per month for 10 years, in 5 years’ time = +/- R534 000
- Over 75 years old (R104 261 + R33 000) = R136 261 or R11 355 per month for 10 years in 15 years’ time = R284 000.
- Total capital requirement to achieve tax threshold on retirement = R337 000 + R534 000 + R284 000 = R1 155 000
Moral to the story Number 1:
- Accept that annuity streams are taxable. But even with a very optimistic outlook on investment returns, capital of R1 155 000 would not actually generate taxable income.
- But the story goes even further --
It is not only the tax threshold that has increased. The marginal rates of tax have been softened considerably over the last 10 years to the extent that the 30% marginal rate now applies only when income exceeds R325 000 per annum.
Thus before there is a real tax problem:
- Thus the true tax threshold for a pensioner today is actually
- Under 65 years old (R325 000 + R22 800) = R347 800
- Over 65 years old (R325 000 + R33 000) = R 358 000
All in R360 000 per annum or R30 000 per month
- Again apply an inflation rate of 6% and a growth rate of 14% (A very optimistic outlook) and a retirement age of 60 and a life expectancy of 25 years. Now calculate the capital required today to yield an income stream that would be below the 30% marginal rate. Answer R8, 045 million.
Moral to the story Number 2:
- Accept that the personal tax marginal rates now escalate far slower than they did in the past. The problem is rather to find a taxpayer with sufficient retirement capital to retire comfortably than to find a taxpayer with a tax problem on retirement.
- And the story does not end at this point.
The second schedule benefits on which the South African retirement planning principles have for so long been based were revised with effect from 1 March 2011 as follows:
All termination payments: Death, retirement or retrenchment
- Don’t look a gift horse in the mouth. If R630 000 displays at an acceptable tax rate then by all means take it.
- SO THAT’S R630 000 TAX EFICIENT ON RETIREMENT
- But wait, there is even more!
Medical expenses are probably the largest single problem in retirement. And there is no medical aid instrument available to save for retirement on a tax-deductible basis. Basically put, the deduction of medical expenses is capped for the under 65 taxpayer.
This does not mean that the taxpayer cannot contribute to a retirement annuity fund that will provide an annuity stream to pay medical expenses and medical aid contributions post retirement.
In short, contributions are made on a tax-deductible basis to a retirement annuity fund - as opposed to adding to any other fund or medical savings plan.
Once retired the taxpayer withdraws taxable annuity income from the retirement annuity. But at 65 years old the taxpayer undergoes a substantial change in tax profile:-
- The income drawn from the retirement annuity fund may remain taxable but
- medical expenses become fully tax deductible.
Moral to the story Number 4:
- Just because an annuity stream is taxable, this is not the end of the world in retirement planning, provided it can be matched with an equal and opposite to tax-deductible expense.
- An ‘executive level’ medical aid currently costs approximately R3 000 per principal member per month. Thus, assuming such a medical aid is required for 20 years in retirement, and applying a 9% inflation rate and a 14% growth rate, the capital sum required to cover medical expenses in retirement would be R453 000. That’s the bad news.
- The good news is that all contributions to the retirement annuity fund would be tax deductible, thus potentially discounting the cost by up to 40 percent.
- Want some more?
The new South Africa works on the basis of ‘one-taxpayer-one-tax return’. The joint taxation of husband and wife had to be abandoned in the early years of the new South Africa as it made for the inconsistent treatment of taxpayers.
With retirement planning, most often there is ‘planning for two’. That gives a doubling up of all allowances across the board. Thus, diagrammatically the classic retirement plan of a new South African family today looks something like…
Please be mindful that a ‘spouse’ for income tax purposes includes any person in a relationship of a permanent nature.
Moral to the story Number 5:
- Correctly planned the RSA taxpayer can save up to R9 million in a retirement fund without incurring a tax charge exceeding 30% on withdrawal. This is based on an optimistic outlook on both inflation and investment returns.
An integral part of retirement planning is the creation of a separate suite of investments and solutions for both husband and wife. Please be mindful that a ‘spouse’ for income tax purposes includes any person in a relationship of a permanent nature.
Some say that there are no tax planning opportunities remaining in the income tax act. Perhaps there are more than ever before.
And then comes the cherry on the top. Yes, there is one!
On death, the value remaining within the retirement annuity funds is exempt from taxation
