As your retirement day draws closer, there are important decisions to be made about how to deal with your retirement savings. A big factor in these decisions is taxation, although it should not be an all-consuming factor, because there are other things you need to consider, such as your health and expected life span, the degree of risk you are prepared to take with your investments, and the costs of those investments.
At a recent presentation for the Ready Set Retire Club, hosted by Alexander Forbes in association with Personal Finance, Jenny Gordon, the head of retail legal support at Alexander Forbes, discussed a number of tax considerations that apply to lump sums from retirement funds and the annuities you buy with your savings, including how having a range of different types of investments can create tax efficiencies when you draw an income in retirement.
If you are close to retiring, you will probably have built up most of your retirement savings in one, or a combination of, the following:
* An occupational retirement (pension or provident) fund;
* Retirement annuities (RAs), if you are self-employed or have saved extra on the side; and
* Preservation funds, if, when you changed jobs, you preserved what you had accumulated.
The investment and annuity options open to you depend, to a certain extent, on the forms your retirement savings take.
If you are one of the declining number of members of defined-benefit pension funds, when you retire, instead of receiving a salary, you will automatically receive a pension from your fund, which is calculated according to your final salary and your length of service. Pay-as-you-earn (PAYE) tax – paid on your behalf by your fund to the South African Revenue Service (SARS) – will be reflected on your monthly pension slip.
If you are a member of a defined-contribution pension fund, or have savings in RAs or preservation pension funds, you are entitled to take up to one-third in each fund as a lump sum. The rest must be annuitised – in other words, you must buy an annuity (pension), which will provide you with a monthly income. (Members of provident funds are treated differently: see “Provident fund withdrawals”, below.)
The SARS table governing your retirement lump sum provides for a tax-free amount of R500 000. For larger amounts, there are tiers to which tax rates from 18 percent to 36 percent apply (see table, below).
Gordon says that the decision on how much to take as a lump sum will differ from person to person, and a financial adviser will have a better picture of your individual circumstances. However, she draws your attention to the tax issues you need to bear in mind in your discussions with your adviser. These are:
HOW MUCH YOU HAVE ALREADY WITHDRAWN
If you have taken a lump sum from your retirement savings during your working life, whether it was when you resigned from a job, or on retrenchment, you have effectively already used part or all of your tax-free benefit in the retirement lump-sum table, Gordon says. This applies to withdrawals after March 1, 2009. This is because your withdrawal amounts are aggregated. For example, if you took R600 000 as a lump sum on resignation from a previous job, you will not get the R500 000 tax-free benefit, because any lump sum you take on retirement will be aggregated with the R600 000 and taxed accordingly.
TAX ON YOUR FUTURE INCOME
Gordon says you need to look at your annuity income, not only on the day you retire, but deeper into your retirement years. It is likely that your tax rate in retirement, and especially in later years, will be lower than in your working years, for the reasons mentioned below.
“Bearing the above principles in mind, one needs to weigh up whether paying tax at 27 percent or 36 percent, the two highest rates in the table, and reinvesting in a discretionary investment is preferable to investing the gross amount in a living annuity portfolio and drawing an income from that,” Gordon says.
Apart from the different rebates, discussed below, the SARS income tax table is the same for all earners, whether working or retired. Your income from a compulsory guaranteed or living annuity will be taxed according to this table.
Gordon says that your income tax in retirement will be lower than during your working life for a number of reasons:
* Your income will probably be lower. Few people manage to retire with savings that generate the same income they enjoyed when they were working. If your income is lower, your marginal tax rate will probably be lower, too.
* You qualify for higher rebates. There are three tax rebates: a primary rebate of R13 257 for all taxpayers, a secondary rebate of R7 407 for taxpayers aged 65 and older, and a tertiary rebate of R2 466 for those aged 75 and older. So if you are 75, you get all three, which currently amounts to R23 130.
The rebates relate to the tax thresholds, or the income levels below which you do not pay tax: R73 650 if you are under 65, R114 800 if you are between 65 and 75, and R128 500 if you are aged 75 or over.
* You must factor into your calculations the fact that the rebates and thresholds are not static. SARS normally increases the rebates and thresholds by the inflation rate (according to the consumer price index) each year, Gordon says.
* You qualify for more generous medical tax credits than under-65s. For most over-65s, the new credit system, which came into operation for pensioners in the 2014/2015 tax year, does not result in a significant difference in your “take-home” money than the old medical expenses deduction system, Gordon says. These credits, she says, work like tax rebates: once you have worked out what tax you pay according to the SARS table, you subtract the credits along with your rebates.
For over-65s contributing to a medical scheme, the member and the first beneficiary each get a fixed credit of R270 a month. Additional beneficiaries get R181 a month.
You also get a third of your medical scheme contributions that exceed three times the fixed credit. In addition to that, you get a third of qualifying medical expenses not covered by your medical scheme.
So, if you add up all the ways you can save on tax, Gordon says, you could structure your finances so that you have different types of retirement income in a “basket”, taking maximum advantage of the exemptions, rebates and credits, and enjoy quite a high disposable income at quite a low tax rate. Comparing this rate with what you would pay on a lump sum that exceeds the tax-free amount, the tax on the lump sum may be relatively high.
TAXES ON INVESTMENTS
With the two-thirds (or more) of your savings with which you buy a compulsory annuity, you essentially have a choice between a living annuity, in which you choose the underlying investments and take the risk that the investments will provide you with an income for the rest of your life, and a guaranteed annuity from a life assurer, which ensures you have a fixed income (level or escalating) for life.
On a living annuity, all growth on the underlying investments is tax-free. You pay tax only on the income you receive. Any remaining capital in a living annuity is not subject to estate duty in your estate when you die. (However, this may change, Gordon points out. She says that the draft Tax Laws Amendment Bill proposes that after-tax contributions to retirement funds will be deemed estate dutiable in your estate.)
With discretionary investments, taxpayers who are 65 or older enjoy a higher annual exemption on interest than under-65s: R34 500 as opposed to R23 800.
Some common investment options for a lump sum or discretionary savings are:
* Unit trusts and exchange traded funds (ETFs). There is 15 percent tax on dividends earned by the investment, interest income above the exemption threshold (of R34 500 a year for people of 65 and over) is taxed at your marginal rate, and when you cash in your units or ETFs, they attract capital gains tax (CGT), subject to an exemption of R30 000 a year. Assets in these funds are subject to estate duty when you die. (Your estate enjoys an exemption from estate duty on the first R3.5 million, and the second-dying spouse can, in addition to his or her own R3.5 million exemption, use any unused portion of the first-dying spouse’s exemption.)
* Property. This attracts transfer duty when you buy. Rental income is taxed at your marginal rate, but you can deduct any expenses related to the property. The sale of property attracts CGT. The property will form part of your estate when you die.
* Shares. Generally, larger investment amounts are required than for unit trusts, Gordon says. Shares attract dividends tax of 15 percent and CGT when you sell and form part of your estate.
* Retail savings bonds. These are interest-based investments, so they attract tax on interest, subject to the R34 500 exemption for over-65s. There are no other taxes, but any money remaining in these bonds when you die will be subject to estate duty.
PROVIDENT FUND WITHDRAWALS
If your savings are in a provident fund or provident preservation fund, currently you can take your entire savings as a lump sum, to do with as you wish. Tax on the lump sum is the same as for other retirement funds (see table, below), with the first R500 000 being tax-free. You may buy a guaranteed annuity from a life assurer with some or all of the money, in which case it will be a voluntary instead of a compulsory annuity, with slightly different tax consequences: you do not pay income tax on the capital that you draw down, only on the growth on that capital, which is a relatively small portion.
The government has passed legislation in terms of which provident funds will be treated the same as pension funds for tax deductions and, like pension funds, at least two-thirds of your savings will have to be used to buy an annuity.
However, this will apply only to savings accumulated after the implementation date, expected to be in March next year.
TAX ON RETIREMENT LUMP SUMS (2015/2016)
R0 to R500 000: 0% of taxable income
R500 001 to R700 000: 18% of taxable income above R500 000
R700 001 to R1 050 000: R36 000 + 27% of taxable income above R700 000
R1 050 001 plus: R130 500 + 36% of taxable income above R1 050 000
TAX TERMS
Rebate: a portion of the total tax amount you owe the South African Revenue Service (SARS) that SARS gives back to you.
“A tax rebate is worth far more to you than a tax deduction,” Jenny Gordon, the head of retail legal support at Alexander Forbes, says. She says it works as follows: from your gross income (some of which is taxable, some not), you subtract things that are exempt, such as share dividends (already taxed), your exemption on any interest income (R34 500 if you’re 65 or over) and your annual exclusion of R30 000 from any tax on capital gains made from, for example, selling shares or unit trusts. Then, from that amount, there are deductions – for example, for contributions to a retirement annuity. You then arrive at what is known as taxable income. On your taxable income, you apply the income tax table. But the figure determined by the table is not what you pay. You then subtract your rebates, to arrive at what you actually owe SARS.
Credit: similar to a rebate, used for medical expenses.
Threshold: an income level below which you are not liable for tax.
Exemption: a portion of taxable income from a certain source that is exempt from tax. For example, the exemption on interest for people over 65 is R34 500, so if your interest income is R36 000, you will be taxed only on R1 500.
Exclusion: usually refers to amounts excluded in the calculation of gross taxable income.
Deduction: an amount you pay from your pocket (for example, for travelling expenses or retirement fund contributions) that you can deduct from your taxable income.
Marginal tax rate: the rate at which you pay tax on the last rand of your income, according to your income bracket in the SARS income tax tables. You don’t pay this on every rand of your income because the rate increases incrementally the more you earn.
Effective tax rate: this is the percentage of your income that goes to SARS after all calculations, including deductions, exclusions, exemptions, rebates and credits.