Tax advantages of a Retirement Annuity
One of the main reasons to use a Retirement Annuity (RA) is the tax advantage, both in the build-up to retirement, as well as in retirement. One tax structure applies when you use an RA to save for retirement, and another when you use the proceeds of an RA to buy an annuity (a pension).
Tax on your contributions to an RA
Up to certain limits, you do not pay tax on the money you contribute to an RA, whereas contributions to an endowment policy are made with after-tax money. When you contribute to an RA, you defer payment of tax on your contributions until you retire and are paid the proceeds of the RA.
This deferment of tax is beneficial in a number of ways. In most cases, when you retire, your marginal and therefore you average income tax rate is lower than when you were working. You are also entitled to certain tax deductions on lump sums paid to you by your RA fund at retirement.
Your contributions to an RA are deductible from your taxable income within certain limits. Your contributions can exceed these limits, but you will not get the tax advantage on the amounts above the limits. Each tax year in which you contribute to an RA, you can claim as a tax deduction the greater of:· 15 percent of your taxable income, excluding your pensionable income, before other tax deductions; or· R3 500 less your current contributions to a pension fund; or· R1 750.
If you contribute more than these limits, you may claim the amounts that exceed the limits in future tax years, provided your contributions in the years in which you claim remain within the limits. Excess contributions may also be added to the tax-free portion of the lump sum you receive at retirement or when your RA matures.
If you are a member of an employer-sponsored or a trade union-sponsored retirement fund, the limit of "15 percent of your taxable income, excluding your pensionable income," is important if you want to contribute to an RA.
As an employee, your salary is made up of two main parts for the purposes of retirement taxation: your pensionable income and your non-pensionable income.
Your pensionable income is normally your basic salary, excluding any allowances, such as a car allowance. Most employers use only your basic salary to calculate how much they will contribute to your pension savings. Some, but very few, employers make pension contributions based on their employees’ gross pay packages (basic pay plus all allowances).
So, your "pensionable income" is the portion of your income that employers use to calculate how much they will contribute to a company-sponsored pension or provident fund.
After deducting your pensionable income from your gross income, you can contribute 15 percent of the balance to an RA and deduct that amount from your taxable income.
Your non-pensionable income is any income you earn that your employer does not take into account when contributing to a company-sponsored pension or provident fund. Non-pensionable income can include allowances paid by an employer, such as your car allowance (but only the portion not claimed as a deductible expense for business travel) and taxable income from other investments (for example, rental income from a second property).
You can reduce your non-pensionable taxable income by contributing 15 percent of non-pensionable income to an RA. In other words, the contributions are deducted from your taxable income, with the result that you pay less tax. If you are on the top marginal tax rate of 40 percent, instead of paying 40 cents in every rand you earn in tax, you will be saving 40 cents on every rand you contribute to your RA. You will also receive investment growth on each of those 40 cents that you save.
Tax on your investments in an RA
The retirement annuity investments build-up on your retirement savings is not entirely tax-free. In 1998, the government introduced Retirement Fund Tax. This is a tax on the interest, foreign dividends and net rental income (any rent on property investments less the costs) earned by any retirement fund, including RAs. Life assurers pay this tax on your behalf at a rate of 18 percent a year.
Tax on your RA benefits
When you retire, the retirement annuity benefits will be subject to tax. You must take two taxation issues into account. These are tax on your lump-sum payout and tax on your monthly annuity.
1. Lump-sum taxation
When your RA matures, you may take one-third as a lump sum and spend it as you wish. You must use the remaining two-thirds to buy a compulsory purchase annuity (a monthly pension).
The tax-free portion of your lump-sum payout from your RA is calculated on the number of years that you have been a member of the fund, multiplied by R4 500. So, if you have been a member of an RA fund for 40 years, you will receive R180 000 tax-free (that is, 40 x R4 500). There is, however, one condition to this: You do not receive the tax-free amount twice.
There is no limit to the number of RA funds that you may join. However, the tax-free portion takes account of all your retirement savings, including your pension fund. You cannot claim it on each source of retirement savings.
As the above calculation indicates, it is to your advantage to join an RA as early as possible so that you derive the maximum tax benefit.
The balance of any lump sum you withdraw in excess of the tax-free amount (from all retirement sources) is taxed at your average rate of tax. The average rate used is the higher of the average rate in the tax year in which you retire or the average rate in the year preceding your retirement. (Your average rate of tax is lower than your marginal rate of tax.)
As a general rule, you should take the entire tax-free portion of the one-third lump sum, even if you do not need the money, and reinvest it. You should avoid withdrawing more than the tax-free portion of your one-third lump sum, because you will lose the benefits of deferring tax on this money.
2. Tax on your annuity (monthly pension)
The minimum of two-thirds you must use to buy a monthly pension is not taxed as a lump sum when you retire. However, the annuity you buy is taxed as income, as and when you receive the money.
Your income in retirement from all sources, including your RA, is taxed at your marginal rate. So, both the capital (on which you did not pay tax when you were saving for your retirement), as well as any growth on the accumulated savings will be taxed at your marginal rate of tax when you receive your pension. You are still able to get investment growth on, and defer tax on, the balance of your retirement capital.
Some tips· The 18 percent Retirement Fund Tax is not levied on the portion of your retirement savings you use to buy an annuity after you retire.· A husband and wife are taxed separately and can each take advantage of the tax breaks in an RA.· If you stop paying your premiums on your RA and resume paying them later to make up for the shortfall, you may deduct R1 800 a year from your taxable income as reinstatement RA contributions.· If you have spare money towards the end of a tax year (February), you should sit down (with a financial adviser if you are not sure of how this works) and calculate the maximum that you can contribute to retirement savings investments to take full advantage of the tax breaks associated with adding a lump sum to your RA fund.
Most employer-sponsored retirement funds do not allow you to contribute additional lump sums to boost your retirement savings. If you are already contributing 7.5 percent of your pensionable salary to the fund, there will be no point in making additional contributions as you will not derive a tax advantage. You should check with your fund whether top-ups are permissible. Most RAs, however, do allow you to make lump-sum contributions to the fund.
To learn more about the top ten things to know before buying a retirement annuity