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Tax on your retirement annuity: How much does the government take?

By Isabelle Coetzee

You picture drinking cocktails out of pineapple shells as you relax on a tropical island. It’s June, and as a retiree you can afford migrating from cold Cape Town to warmer pastures.

At least, this is what you believe you’ve worked for. However, when you finally receive your pay-out and you notice the large tax deduction, your spirits cave.

This week Justmoney found out how much tax you will have to pay on your retirement annuity (RA), and why this is important. But first, let’s establish what a RA really is.

What is an RA?

According to Pat Blamire, certified financial planner at Chartered Wealth Solutions, South Africans are encouraged to provide for their own retirement savings.

“As a reward for this, there are certain tax deductions that can be claimed on these contributions,” she explains. 

“Many companies provide their staff members with a retirement fund, which provides a compulsory saving towards retirement.

“The employer automatically deducts the agreed retirement savings amount from the employee’s salary and pays this across into the retirement fund,” says Blamire.

“For individuals who are self-employed or employed by a small company, an RA investment is the perfect investment to provide for their retirement savings,” she adds.

Blamire points out that current legislation requires a limited tax deduction of 27.5% on the taxable income, including capital gains, but capped at an annual limit of R350,000.

RA actually saves you taxes

According to Danie Venter, certified financial planner at Citadel Advisory Partner, you shouldn’t be angry about your tax deduction.

“Many South Africans have taken out RA on the premise of enjoying tax savings.

“But they don’t receive adequate advice regarding the tax treatment of both the contributions towards the RA, as well as the income received from the RA after they retire,” says Venter.

To illustrate, he uses the following example:

“Assume you earn R300,000 per annum and make no contribution towards an RA. You would pay R48,265 in taxes,” says Venter.

“If you contribute the 27,5% of your annual income (R82,500) towards your RA, your total tax liability would reduce to R26,815. This creates a tax saving of R21,450.

“In other words, of the R 82,500 contribution made towards your RA, you have ‘redirected’ the R 21,450 tax expense into a saving to fund your retirement,” explains Venter.

He points out that there are no taxes you need to declare or pay within your RA until the day you reach retirement (minimum age of 55).

Once you reach this point, Venter explains you will have to choose between one of two options:

  1. Convert the total RA into a pension which pays you a monthly or annual income.
  2. Take up to a third of the RA value as a capital payment to you and convert the remaining two thirds into a pension which pays you a monthly or annual income.

“It’s important to bear in mind that the amount that you take out of the portfolio as a capital payment is subject to upfront taxes,” says Venter.

“In both scenarios above, the monthly/annual income that you receive will be taxed as income in your hands as per the usual tax tables available on the SARS website.

“Should you be older than 65 years when you retire, you would benefit from an additional tax rebate of R7,713.

“And at the age of 75 this rebate would increase by a further R2,574, marginally reducing the overall taxes paid on the income you receive,” he explains.

Tax benefits clarified

According to Eugene Maree, managing director at Wealthport, a retirement fund falls outside of your estate.

“This means that when you pass away no estate duty is due, which is between 20% and 25% depending on the size of your estate,” says Maree.

“Further to this, a Retirement Annuity is not subject to Capital Gains Tax (CGT) or Dividends Withholding Tax (DWT),” he explains.

Maree adds that Section 10C of the Income Tax Act makes provision for Disallowed Contributions (DC) to be taken as a tax-free income or lump sum at retirement.

Therefore, he explains that DC (anything above the cap of R 350 000,00) that have not been taken out become part of your estate after death.

“In simple terms the tax man gives you a tax break to encourage you to save for your retirement. This is done by giving you tax back on the portion you save,” says Maree.

“In the event that you contributed more than the maximum amount of R350 000, you don’t get the tax back on that portion but you can withdraw tax free on retirement as you have already received the tax on that portion as it was considered ‘after tax income’,” he adds.

Maree uses the following example to highlight this:

 

Taxable income from lump sum benefits

Rates of tax

R 0 – 500,000

0% of taxable income

R 500,001 – 700,000

18% of taxable income above R 500,000

R 700,001 – 1,050,000

R 36 000 + 27% of taxable income above R700,000

R 1,050,001 and above

R 130,500 + 36% of taxable income above R1,050,000

​​

Example

Janet received a lump sum of R682,000 from the ABC Pension Fund and had received no previous lump sums prior to this. Over a number of years, the total contributions which did not previously rank for deduction or qualify for exemption in Janet’s hands amounted to R50,000. Calculate the normal tax payable on this lump sum.
 
Result
 
The gross lump sum on which normal tax will be calculated amounts to R682 000 less R50 000, which equals R632 000. R632,000 falls within the taxable income bracket of R500,001 to R700,000. The normal tax is therefore 18% of the taxable income above R500 000. Thus:
 
Normal Tax
= 18% of (R632,000 - R500,000)
= 18% of R132,000
= R23,760

The normal tax on the lump sum of R682,000 therefore amounts to R23,760, and the net lump sum after tax (“cash in pocket”) would equal R658,240.

 

 

Guaranteed vs. Living Annuity

According to Tracy Jensen, Chief Financial Officer at 10X Investments, there are two types of pay-outs you can receive from a RA. 

“When a RA is claimed, the holder must use at least two-thirds of the proceeds to buy an annuity, which can be either a living or a guaranteed annuity,” says Jensen.

“With a living annuity, the holder has some discretion to choose their own income.

“On the other hand, with a guaranteed annuity, the annuity depends on factors such as age, gender, and the type of annuity chosen,” says Jensen.

Combo: RA plus discretionary savings

Venter believes there are alternatives to a typical RA.

“This is where a financial strategy is crucial to help you navigate your way through the financial maze,” says Venter.   

“To achieve a more tax-optimal scenario at retirement, you need a fine balance between retirement savings and discretionary savings (non-retirement contributions),” he explains.

He points out that tax treatment of both retirement and discretionary savings vehicles are vastly different.

“The first being taxed as income (maximum rate 45%) and the latter being subjected to capital gains tax (maximum rate 18%),” says Venter.

He makes the following two suggestions:

  • Ensure the investments made are invested in the correct asset classes to achieve higher returns over your lifetime. Cash returns, albeit very low risk, wouldn’t be appropriate for long term investment given the impact of inflation.
  • Make use of beneficial tax vehicles, such as Tax-Free Savings Accounts (TFSA) prior to investing in other vehicles available. 

According to Lance Solms, managing director at Itransact, TFSA’s allow an investment of R33,000 per year and a lifetime limit up to R500,000 – likely to be revised upward in future.

“These investments can be made in a number of different asset classes and all gains on these investments (capital gains, dividends, and interest) are completely tax-free,” says Solms.

“However, contributions are not tax deductible, which is why TFSA’s should only be considered to supplement whatever retirement savings an individual already has,” he explains.

“This is especially true if they are at (or near) the contribution limit of 27.5% of taxable income,” he adds.

Tips from a sceptic

According to one South African blogger, who prefers to remain anonymous, the tax payable at the end of an RA is one of the main reasons he dislikes them.

He’s pursuing early retirement at the age of 45 through following principles from the FIRE (Financial Independence and Retiring Early) movement. Check out his journey here.

This movement aims to reduce living costs and increase savings and investments. This requires a lot of research and, based on what he’s learned so far, he offers the following tips:

  • The tax on the lumpsum can be reduced if you do not take the full 1/3. This means that you use more of the value of your investment to buy an annuity, and you get less cash out. This may be preferable for some people.
  • The lower your cost of living in retirement, the less income you will need to cover your costs. Less income equals less tax.
  • If you can live off other investments, or keep working and delay converting your retirement annuity into a living or life annuity, it will push you closer to the 65-year mark which means you get a higher rebate each year
  • An RA is what is known as a deferred tax product. The contributions are tax deductible up front when you make them, but then you get taxed at the end. The reason you pay Tax once your RA matures is because SARS gave you a Tax benefit upfront.

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