The series of columns on what to consider when investing discretionary lump sums at retirement ended last week, but I am extending the series by a week because of the sharp eye and knowledge of Joe Gates, a director of Johannesburg-based financial services company Hewitson & Gates Financial Consultants.
Gates, a lawyer who has the Certified Financial Planner accreditation, is eminently qualified to give sound advice. He pointed out that I left out an important option for some provident fund members.
I wrote three weeks ago that a cash lump sum paid out by a provident fund is subject to retirement fund lump sum tax – that is, tax must be paid on the employer’s contributions plus the investment growth. (Note: The first R315 000 plus the provident fund member’s own contributions can be taken tax-free. The next R315 000 taken as a lump sum is taxed at 18 percent, the next R315 000 is taxed at 27 percent, and you will pay tax at 35 percent on any amount you take as a lump sum in excess of R945 001. The same tax rates apply to members of pension funds, but they cannot add their contributions to the tax-free amount.)
I wrote that a member of a provident fund should consider investing the cash lump sum in either a voluntary purchase annuity (VPA) bought from a life assurance company or an income plan, where you decide on the underlying investments, to provide an income stream in retirement.
If you belong to a pension fund, including a retirement annuity (RA) fund, you may take up to one-third of your retirement benefit as a cash lump sum, and you must use a minimum of two-thirds of your benefit to buy a compulsory purchase annuity (CPA) – a pension for life.
The reason the benefits paid out by a pension fund (including an RA fund) and a provident fund are taxed in different ways is that you cannot claim your contributions to a provident fund as a deduction against your taxable income, whereas you can deduct your contributions to a pension fund and an RA fund.
When you retire, a CPA and a VPA are taxed differently:
However, Gates correctly points out this is not the end of the line for all provident fund members.
Where membership of, and contributions to, a provident fund have been funded with employer contributions (the member has made no contributions), lump sum tax can be avoided on the entire retirement benefit if the rules of the provident fund permit members to purchase either a traditional guaranteed CPA from a life assurance company, or an investment-linked living annuity (illa). This is a significant advantage to you, because, instead paying lump sum tax upfront, you defer paying tax until the money is paid to you as a pension.
Such a provident fund member would then still be subject to income tax at their marginal rate on their entire pension – not the capital portion only as with a VPA.
There are some important provisos for taking the CPA option:
Peter Stephan, senior policy adviser to the Association for Savings & Investment SA, says if the rules do not allow you to purchase a CPA, the taxman could argue that all the money accrued to you as a lump sum and is therefore subject to lump sum taxation. Many provident funds now do have rules that allow a benefit to be transferred to a CPA.
Stephan says that, in effect, the CPA option is achieved by the provident fund’s rules providing that a member is entitled to an annuity at retirement but subject to the member being able to commute up to 100 percent as a cash lump sum, giving the member flexibility of choice.
Provident funds where members do not make contributions are most often top-up funds for company senior executives, or funds with a membership that consists mainly of high-income earners, where the members have negotiated with the employer for a lower remuneration package in return for the employer paying that money into a provident fund for their benefit.
However, even when a provident fund member has made contributions, there could be a solution, because you can take as much of the benefit as you want as a lump sum at retirement. So you could elect to take the tax-free portion of R315 000 plus your own contributions (which would also be tax-free), and then use the balance to buy a CPA – either as a traditional guaranteed pension from a life assurance company or as an illa.
Stephan warns that this is a complicated issue, and the appropriate decision will depend on the personal circumstances of each provident fund member.
These circumstances include your health and age at retirement, which will determine your life expectancy; how much of the tax-free lump sum you have used previously; your income needs; how many dependants you still have; whether you have debts, such as home loan payments; your general estate planning objectives; and the prevailing interest rates.
“There is no right or wrong solution – it all depends on your needs and circumstances,” he says.
What is important, Stephan says, is that you obtain sound advice on which option would suit you best.
Furthermore, the correct administrative process must be followed when the benefit is transferred to a CPA, or you could find yourself subject to double taxation.
Finally, the purpose of what has turned out to be a five-column series is to encourage retirees to consider carefully all their options on what to do with discretionary money at retirement and in retirement.