This article was first published in the third quarter 2016 edition of Personal Finance magazine.
Retrenchments have become a common occurrence as companies struggle to stay profitable in the current economic climate.
As prescribed by the Basic Conditions of Employment Act, a severance package must be paid to a retrenched employee at a minimum rate of one week’s salary for every year of service. If you do not have many years of service, or your salary is relatively small, this package might not be sufficient to maintain you until you find a new job. This can force you to dip into your retirement fund. How are such withdrawals taxed under these circumstances?
This is best explained by using an example: John, who is 53, has worked for BDY Company for a number of years and was retrenched in January 2016. He receives a severance package of R600 000, pay in lieu of leave of R30 000, a pro rata share of his annual bonus of R80 000 and a final salary of R40 000. He decides to take R400 000 from his pension fund and to invest the balance in a preservation fund until his retirement.
The first thing to note is that any leave pay, pro rata bonus and final salary do not form part of the severance package and are taxed according to normal income tax rates.
From March 1, 2011, a concession has applied that makes all severance benefits taxable according to retirement tax scales (refer to this table) if one of the following requirements is met, as provided for in section 1 of the Income Tax Act:
* You are 55 years or older;
* You are incapable of holding employment because of sickness, injury or incapacity; or
* The termination or job loss is a result of one of the following:
– Your employer ceased to carry on, or intends to cease carrying on, the trade in respect of which you were appointed; or
– You have become redundant as a consequence of a reduction in personnel by your employer.
A severance package must meet one of the above requirements to be taxed at the retirement tax scales.
Remember that John is receiving a severance benefit of R600 000 and will take R400 000 from his pension fund – a total of R1 million.
It is important to remember that the South African Revenue Service (SARS) applies the aggregation of lump sum principle, so all lump sums withdrawn from retirement funds – past, present and future – are aggregated, or added together. In other words, the following lump sums must be aggregated when the tax is calculated on the current lump sum that John is taking:
* All withdrawal lump sums after March 1, 2009;
* All retirement lump sums that accrue after October 1, 2007; and
* All severance benefits after March 1, 2011.
John’s tax calculation will be as follows (refer to the sliding scale in the table): [(R1 million – R700 000) = R300 000] x 27 percent + R36 000 = R117 000.
The employer must submit a tax directive application to SARS before the lump sum can be paid.
Although a severance benefit is taxed as a retirement lump sum, the lump sum cannot be preserved in the employer’s retirement fund, or in a preservation fund. The after-tax lump sum can, however, be invested in a retirement annuity (RA) fund.
It is important to take note of the new section 3(2)(bA) of the Estate Duty Act, which became effective on January 1, 2016 and is applicable to the estate of anyone who dies on or after that date in respect of contributions made on or after March 1, 2015. In terms of section (bA), if John were, for example, to make his after-tax benefit (say, R550 000) payable to an RA as a lump sum (after March 1, 2015) and then pass away after January 1, 2016, any contributions that he had not been able to deduct (that is, contributions in excess of 27.5 percent of the greater of taxable income or remuneration) would be added in as a deemed asset for estate duty purposes.
In conclusion, it is important to remember that you receive the tax-free amount (R500 000) only once, so if you take it earlier, it will not be available to you again on retirement. An additional lump sum taken on retirement would then be taxed according to the sliding scale below. So it’s important, if you are retrenched, to contact a professional person who can assist with advice about tax and investments.
* Daleen Harris is a member of the Fiduciary Institute of Southern Africa, has the Certified Financial Planner accreditation and is a legal adviser specialist at Old Mutual.