At the recent Personal Finance/First National Bank Successful Retirement Seminars held around the country, Harry Joffe, the head of legal services at Discovery Life, spelt out the important relationships between you, the taxman and your retirement savings.
The key to how you fund your retirement is how your contributions to a retirement fund are treated for tax purposes, Harry Joffe, the head of legal services at Discovery Life, says.
There are three stages, or levels, at which your retirement savings will be affected by tax, he says. When you are contributing to a fund, your contributions may be a tax deduction and thereby reduce the tax you pay; when the money is growing in your retirement fund, your fund will pay tax on certain parts of that growth; and when you withdraw the money from your fund when you resign or retire, there are tax implications.
To make the most of your retirement savings, you need to be aware of the tax implications at each of these stages, Joffe says, and you must keep an eye on imminent changes to the taxation of retirement savings which could affect your future planning.
THE DEDUCTIBILITY OF CONTRIBUTIONS GOING INTO
YOUR RETIREMENT FUND
When you contribute to a retirement fund, you may be able to deduct some or even all of your contributions from your taxable income, depending on whether you belong to a pension fund, a retirement annuity (RA) or a provident fund, Joffe says.
The tax deductibility of the contributions you make to these different retirement funding vehicles is linked to the taxation of the benefits that you receive when you retire, he says.
Pension fund contributions
If you are contributing to a pension fund, the amount you can deduct from your taxable income is the greater of:
- R1 750 for the tax year; or
- 7.5 percent of your "retirement funding income" for the tax year.
Joffe says it is up to your employer and the trustees of your retirement fund to decide what constitutes retirement funding income. For example, your employer may decide that your travel allowance does not constitute retirement funding income and your pension fund contributions will then be based on what you earn excluding your travel allowance. If you earn overtime, this is also likely to be non-retirement funding income.
Provident fund contributions
If you are contributing to a provident fund, you will not be able to claim any of your contributions to the fund as a tax deduction, Joffe says. Your employer will, however, be able to claim a deduction for contributions made to the fund on your behalf. This deduction is, however, limited to no more than 20 percent of your remuneration.
Joffe says that in practice employees do not contribute to their provident funds. Rather they sacrifice part of their salary in return for a greater contribution by their employer who does enjoy a tax deduction within the 20 percent limit.
RA contributions
If you are contributing to an RA, Joffe says, you can claim the greater of the following as a tax deduction:
- 15 percent of your non-retirement funding taxable income (that is 15 percent of any taxable income which is not used to calculate a contribution to a pension or provident fund); or
- R3 500 less any contributions to an approved pension fund for which you already enjoy a tax deduction; or
- R1 750.
THE TAXATION OF GROWTH ON THE MONEY IN THE FUND
Joffe says that before March 1, 1996 retirement funds were not taxed. But in 1996 the Tax on Retirement Funds Act was passed and retirement funds now pay tax at a rate of 18 percent on any interest, foreign dividends and net rental income that the fund earns, Joffe says. This applies to pension funds, provident funds and retirement annuities.
A tax rate of 18 percent is what anyone in the lowest tax bracket pays (R30 000 - R70 000 a year for people under the age of 65). For anyone earning more than R70 000 a year and who has exceeded the tax exemptions on interest income (the first R11 000 for people under the age of 65), the tax their fund pays is better than what they would pay on savings outside the retirement fund.
The 18 percent tax rate on retirement savings is not favourable for people earning less than R70 000 and particularly unfavourable for those earning less than R30 000, because their income tax rate is less than 18 percent and in the case of people earning less than R30 000, they pay no tax.
This is one of the issues that has prompted the government to review its taxation of retirement savings. The review of the taxation of retirement funds is likely to include a review of the exemption from capital gains tax that funds currently enjoy.
THE TAX CONCESSIONS AND LIABILITIES WHEN YOU LEAVE YOUR FUND
The tax you pay on the money you are paid out from your retirement fund differs, Joffe says, depending on whether you resign and withdraw from the fund or whether you retire from the fund. There are also differences between the taxation of the payments in either case, depending on whether you are a member of a pension fund, provident fund or RA.
Resigning from a pension fund
If you resign from your pension fund, you are entitled to withdraw an initial amount tax free, but if you withdraw the balance, you will pay tax on it at your average tax rate, Joffe says.
The initial tax-free amount you are allowed to withdraw, he says, is the greater of:
- R1 800; or
- Contributions which were not allowed as a tax deduction in the past.
Retiring from a pension fund
If you retire from a pension fund at the retirement age specified by the fund or because you are disabled and unable to work, you can withdraw one-third of the amount in your fund, Joffe says. With the other two-thirds, you have to buy an annuity that will pay you a monthly pension.
To work out how much of the one-third is tax free, you have to apply two formulae, he says. The first formula determines how much you are entitled to tax free and the second limits the amount.
The first formula:
One-tenth multiplied by your highest annual salary over any five consecutive years (to a maximum of R60 000), multiplied by the number of years you have been a member of the fund (to a maximum of 50 years), plus your own contributions which were not allowed as a tax deduction in the past.
For example, using this formula, for anyone earning more than R5 000 a month or R60 000 a year, who has been a member of their fund for 10 years, the tax-free amount is:
1/10 x R60 000 x 10 = R60 000
The second formula:
The second formula limits the amount that can be taken tax free from what you calculated in the first formula to the greater of:
- R120 000 plus the contributions which were not allowed as a deduction in the past; or
- R4 500 x the number of full years of membership, plus the contributions which were not allowed as a deduction in the past.
Joffe says people are often told that they will get at least R120 000 tax free from their pension funds, but this is only the case when you have been a member of your final fund from which you retire for more than 20 years. If you have been a member of your final fund for 40 years, the most you will get out tax free is R180 000 (R4 500 x 40).
He also points out that when you transfer your savings from one pension fund to another, you do not carry across years of service.
Once you have deducted the tax-free portion from your one-third lump sum, the rest is taxed at your average rate of tax, Joffe says.
Your average rate of tax is the total tax you pay divided by your total income, expressed as a percentage. This will almost always be less than your marginal rate. Usually if you are on the highest marginal tax rate of 40 percent, your average tax rate will be between 35 and 38 percent, he says.
When you receive the annuity payments from the annuity you must buy with the remaining two-thirds of your fund, you will pay normal income tax at your marginal tax rate.
Resigning or withdrawing from a provident fund
When you resign or withdraw from a provident fund, as is the case with a pension fund, you are entitled to withdraw an initial amount tax free, but if you withdraw the balance, you will pay tax on it at your average tax rate, Joffe says.
The initial tax-free amount you are allowed to withdraw is the greater of:
- R1 800; or
- Contributions which were not allowed as a tax deduction in the past.
Retiring from a provident fund
When you retire from a provident fund, at the normal retirement age or because your are disabled, you can withdraw the full amount, Joffe says. You are not obliged to buy an annuity with a portion of the money, although this may be the sensible thing to do.
To work out how much of your withdrawal is tax free, he says, you have to apply the same two formulae used to calculate the tax-free withdrawal from a pension fund.
However, in the case of a provident fund, Joffe says, should the amount calculated from the formulae be less than R24 000, you may take R24 000 tax free, plus any contributions that you were not allowed to deduct from your tax in the past.
The portion that is not tax free is taxed at your average rate of taxation, Joffe says.
Retiring from an RA
You cannot resign or withdraw from an RA - you can only get your money out of an RA at the retirement age for these products, which is 55 years of age. The only exception, Joffe says, is if you need to take early retirement because you are disabled.
Otherwise, if you are unable to continue to make contributions to an RA, it is regarded as "paid up" and the money you have contributed continues to earn interest until you reach retirement age.
You can transfer your savings in an RA to another RA. When you reach age 55 or at a later retirement date, you can withdraw up to one-third of your RA savings in cash, Joffe says, but the rest must be used to buy a monthly annuity. This one-third taken in cash will be tax free within the following limiting formula.
The tax-free amount is limited to the greater of:
- R120 000 plus your contributions which were not allowed as a deduction in the past; or
- R4 500 multiplied by the number of years of membership plus your contributions which were not allowed as a deduction in the past.
IT COULD ALL CHANGE
The government's review of the tax treatment of retirement savings could soon result in a change in the taxation of your retirement savings, Joffe says. Although the government has been reconsidering its taxation of retirement savings for the past few years, Finance Minister Trevor Manuel has assured that he will announce the draft proposals for the changes in next years' Budget, Joffe says.