Sanlam : Using a retirement annuity as an estate planning tool

Additional contributions to an RA provide opportunities for astute estate duty and financial planning.

22 July 2014. Compiled by: Tiny Carroll, Fiduciary Specialist at Glacier by Sanlam

We first published the idea of using a retirement annuity as an estate planning tool in January 2008. Our initial article was amended in August 2009, and again in March 2011. This, the fourth version, has been drafted to include the latest amendments to the Income Tax Act ('the Act') brought about by the Taxation Laws Amendment Act of 2013. While some of these amendments are already applicable (for example the section 10C exemption which came into effect on 1 March 2014), others only come into effect on 1 March 2015. The commencement date of each amendment will be indicated.

This article focuses mainly on the estate duty and income tax benefits afforded by a single premium contribution to a retirement annuity fund.

Current contributions
(the new section 11(k)(i) comes into effect on 1 March 2015)

The allowable tax deductions in respect of contributions to retirement funds will change significantly from 1 March 2015. The Act no longer distinguishes between retirement annuities and employer funds, i.e. pension and provident funds. The old section 11(n) which applied to retirement annuity contributions has been scrapped and is replaced by a new section 11(k). (The old section 11(k) dealt with employee contributions to pension funds.)

In terms of the new section 11(k), the aggregate contributions to all funds (including provident funds) will be deductible but subject to the following limits:

The lesser of:
R350 000.00
or
27.5% of the greater of 'remuneration' or 'taxable income'

For the purposes of section 11(k) -
"remuneration" includes:

• income from employment, annuity income (including living annuities), and the taxable value fringe benefits.
  
  

"remuneration" excludes:

• retirement fund lump sum benefits, retirement fund withdrawal benefits, and severance benefits.
  
  

"taxable income" (includes remuneration)

• is calculated normally, but before taking the section 11(k) deduction into account, and
• excludes retirement fund lump sum benefits, retirement fund withdrawal benefits, and severance benefits.
  
  

The significance of the distinction between 'remuneration' and 'taxable income' can be illustrated by way of the following example:

Mr K is employed and earns a salary of R500 000.00 p.a. He also runs a small IT business in his spare time. The IT business has suffered an assessed loss of R500 000.00. While his taxable income will be nil, he will still be allowed a deduction in respect of a retirement fund contribution based on his remuneration of R500 000.00.

His allowable deduction will thus be limited to R137 500.00, being the greater of taxable income or remuneration and less than the overall ceiling of R350 000.00.

(the new section 11(k)(ii) comes into effect on 1 March 2015)

Contributions disallowed in any previous year of assessment solely because they exceeded the tax deductible limits in that year, will be deemed to be a current contribution for the current tax year.

In simple terms, the Act allows for the following:

• Any excess contribution will roll over to the following tax year, where it will be deductible as a deemed current contribution within the normal current contribution deduction limits discussed above.
• The amount which may be carried forward each year must be reduced by:
  • the amount of the excess contribution that has been used to reduce the taxable portion of any lump sum retirement benefit or lump sum withdrawal benefit; and
  • the amount which has been allowed as an exemption under section 10C. (The section 10C exemption will be dealt with below.)
    
    

Mrs Jones makes an excess contribution of R1 million to a retirement annuity fund in the 2014 tax year.

The excess rolls over to the 2015/16 tax year and will qualify to be deducted within the limits imposed by section 11(k)(i).

Assume that Mrs Jones' qualifying taxable income for the year is R500 000.00. She will qualify for a deduction of R137 500.00 (R500 000.00 x 27.5%). If she elects to contribute R50 000.00 as a current contribution for the year, she will still qualify for a deduction of R137 500.00. The deduction will consist of two components, being:

• R50 000.00 as her current contribution, and
• R87 500.00 as a deemed contribution (being a portion of the excess contribution).
  
  

The remaining portion of the excess contribution R912 500.00 now rolls over to the following tax year.

(We will continue to build on this example as this article progresses).

Employer contributions
(the new section 11(k)(iii) comes into effect on 1 March 2015)

Any amount contributed by an employer to a retirement fund for the benefit of an employee will be included in the employee's taxable income as a taxable fringe benefit (Paragraph 2(l) of the 7th Schedule) and will be deemed to be a contribution by the employee.

The employer will be able to claim a deduction as an expense incurred in the production of income, while the employee will be able to claim a deduction as a contribution to the fund within the limits set out above.

For the purposes of section 11(k) a partner in a partnership will be regarded as an employee.

New scales for lump sum benefits were announced in the 2014 Budget and came into effect in respect of lump sums accruing on or after 1 March 2014.

At retirement, the member will have the option of electing up to a third as a cash lump sum. Lump sums taken at retirement will be subject to the following tax concessions:

NOTE: On death, the full benefit may be taken in the form of a lump sum. Where the beneficiary/ies elect to take any benefit in the form of a lump sum, the lump sum will be deemed to have accrued to the deceased member on the day before his/her death and will be taxed in accordance with the above table, at the deceased's rates. In effect, the beneficiary bears the tax liability, if any, in the form of a reduced benefit.

Mrs Jones retires in 2016 and elects a lump sum of R250 000.00.

The taxable portion of the lump sum to be included in the "retirement tables" must be reduced by the remaining available excess contributions (R912 500.00) first.

The R250 000.00 is treated as an excess contribution and will not be taxed. The remaining balance of the excess contribution reduces to R662 500.00 but qualifies for a further tax concession in the form of an exemption allowed against the annuity income, in terms of a new section 10C.

The annuity exemption
(the new section 10C came into effect on 1 March 2014)

The provisions of the new section 10C came into effect on 1 March 2014. The new section exempts certain annuity income from income tax, to the extent of the taxpayer's excess contributions to any retirement fund.

Section 10C therefore means that the total of all annuities received by a retiree from any:

• Pension Fund
• Preservation Pension Fund, and
• Retirement Annuity Fund
  
  

will be exempt from income tax to the extent of the taxpayer's excess contributions to any one of these.

NOTE: While "excess" contributions to a provident fund may be taken into account for the purposes of calculating the total amount of excess contributions, annuities emanating from provident funds and preservation provident funds will not be exempt.

(It is anticipated that the exemption will be extended to annuities emanating from provident and preservation provident funds once provident funds become subject to compulsory annuitisation after 1 March 2015.)

The annuity emanating from a provident fund will qualify as remuneration for the purposes of calculating the member's current or deemed current contribution.

In 2016 Mrs Jones receives an annuity of R100 000.00 and no other income. The R100 000.00 annuity income will be exempt in terms of section 10C and the remaining excess contribution, as it existed at the start of 2016 (being R662 500.00), must reduce by a further R100 000.00.

Assuming that Mrs Jones has no other taxable income, her annuity income will continue to be exempt until all her excess contributions have been accounted for. Put differently, she will enjoy an exempt annuity for just over 6 years.

If Mrs Jones continued to receive other qualifying taxable income of R500 000.00 in addition to her annuity, she would qualify for the following tax concessions on a "gross income" of R600 000.00.

R100 000.00, being her annuity income, will be exempt (in terms of section 10C).

In addition to the exemption Mrs Jones will allowed a deduction of R137 500.00 as a deemed current contribution (in terms of section 11(k) (ii)).

In this scenario, her remaining excess contribution (R662 500.00) must be reduced by the R237 500.00 for the tax year - being the R100 000.00 exemption and the R137 500.00 deemed current contribution.

Since the abolition of Retirement Fund Tax, the build-up in retirement funds, including the assets backing a living annuity, is totally tax free.

The old rule that the member had to retire from a retirement annuity at age 69 has fallen away.

This has a two-fold benefit:

• Persons over the age of 69 may now join a retirement annuity fund to
  • reduce their tax on the monthly taxable income, and / or
  • reduce the dutiable value of their estate from an estate duty perspective.
• The member never has to retire from the fund
  
  

Contributing to a retirement annuity will allow the contribution to be taken out of an estate without attracting donations tax, but with the added benefit of an income tax deduction within the limits discussed above.

On the death of a member, any benefit (including lump sums) payable in consequence of membership of a retirement fund will be excluded from the deceased's estate for estate duty purposes. Therefore, in addition to the income tax advantage, the contribution to the retirement annuity will reduce the dutiable value of the planner's estate by 20% (being the current estate duty rate) of the contribution. Any growth on the contribution also takes place outside of the planner's estate.

The combination of estate duty and CGT payable at death poses an enormous threat to the value of a client's estate.

Retirement annuities are not subject to CGT (or estate duty).

For planners with the correct profile, investing in a single contribution retirement annuity and then electing a living annuity can be likened to being a beneficiary of a trust.

The amount applied to buy the annuity does not form part of the member's estate for estate duty purposes. A living annuity has the following additional benefits:

• It is protected against creditors in the case of insolvency or divorce. Legislation aimed at including the value of a living annuity as an asset for the purposes of divorce is in the offing.
• A beneficiary/ies can be nominated to receive the remaining fund value upon the death of the member.
• The member may select the underlying assets in which the annuity is to be invested - subject to prudent investment limits.
• No Capital Gains Tax, Income Tax or Retirement Fund Tax is payable on the assets backing the living annuities.
• The percentage and frequency of payouts can also be selected. This means that the investor can regulate income flows annually on the anniversary of the contract. The income percentage on all new contracts concluded after 1 March 2007 may not be less than two-and-a-half per cent (2,5%) (simple interest rate of return calculation) and may not exceed seventeen-and-half per cent (17,5%) (simple interest rate of return calculation) - subject to the condition that the annuity will be for the life of the annuitant.
• The annuity income (other than from provident funds) received by the member will be exempt to the extent of the member's excess contributions.
  
  

Mr Smith is 80 years old and has an estate duty 'problem'. Part of his estate consists of a share portfolio of R5 million (the base cost of which was R4 million).

Compare the position where he retains the shares in his own estate to what the position would be if he sold the shares and transferred the proceeds to a retirement annuity with the same underlying portfolio. Subject, of course, to the 25% that will have to be invested in prudent instruments.

Assume he never retires from the fund and his beneficiaries elect to take the full benefit as a lump sum on his death. Ignore growth for the sake of the example.

If Mr Smith is reliant on the income from the share portfolio, he will have the option to retire from the retirement annuity fund immediately and utilise the proceeds to buy a living annuity.

His annuity income would be exempt in terms of section 10C above. There is an added benefit: the yield on his investment will not be subject to the 15% dividend withholding tax suffered by his share portfolio. He has, in effect, given himself an increase of 15%.

If Mr Smith elects the minimum income of 2.5% based on a capital R4 866 700, he will receive an exempt annuity of R121 668 each year.

If, for the sake of the example, Mr Smith has had the benefit of three exempt annuities before his death, the remaining excess contribution on his death will be R4 501 697.00 (R4 866 700 - R365 003).

If Mr Smith's beneficiary elects to take the benefit in the form of an annuity, future annuities will not be exempt. It is only the member who qualifies for the exemption.

Mr Smith's beneficiary could "preserve the exemption" by doing the following:

• Electing to take the benefit in the form of a lump sum;
• contributing the lump sum to a new retirement annuity.

The contribution becomes a "new" excess contribution and qualifies for the concessions discussed above.

(The lump sum elected by the beneficiary on Mr Smith's death will accrue to the deceased and will only be taxable to the extent that the amount exceeds the balance of his excess contributions plus any unused portion of the R500 000.00 concession)

The beneficiary's decision to commute or elect a living annuity requires the assistance of an astute financial adviser.

A single premium retirement annuity fund contribution provides a planner with an opportunity to:

• make additional provision for his /her retirement;
• have an income tax saving in the form of deductions;
• have an income tax saving in the form of a tax free lump sum;
• have an income tax saving in the form of an exempt annuity;
• avoid CGT and dividends tax;
• avoid estate duty and estate administration expenses;
• ensure a protected income source at death or retirement for him-/herself and his/her dependents or beneficiaries.

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