Retirement annuities (RAs) will remain a great estate-planning tool despite new restrictions on contributions, Jenny Gordon, the head of retail legal support at Alexander Forbes, says.
Some of the provisions in the Taxation Laws Amendment Bill, which is before Parliament, are designed to clamp down on wealthy people who over-contribute to retirement funds in order to reduce their income tax and estate duty.
You can claim a tax deduction of up to 7.5 percent of your pensionable income on annual contributions to an occupational retirement fund and up to 15 percent of your taxable income, less your pensionable income, on contributions to an RA fund.
Some wealthy people contribute more to an RA than the maximum deductible contribution of 15 percent of non-retirement-funding income. Although the excess amounts are not tax-deductible, they earn investment returns that are not subject to tax, and they can pass on the money in the RA to their beneficiaries free of estate duty.
The amendment bill states that any retirement fund contribution made from March 1 next year that does not qualify for a tax deduction will be included in the estate, for estate duty purposes, of people who die on or after January 1 next year.
Gordon says the amendment does not apply to contributions that qualify for a tax deduction under the current tax regime or the new regime that is scheduled to take effect on March 1, 2016.
Under the new regime, annual contributions to a retirement fund will be tax-deductible up to 27.5 percent of the higher of your remuneration or taxable income, but with a cap of R350 000 a year.
Contributions that do not qualify for a tax deduction can be rolled over to a following year, when you can claim them if you do not use your full tax deduction in that year.
Gordon says the restriction on the estate duty exemption for RA contributions applies to so-called “death bed” lump-sum contributions made with after-tax money.
On your death, your beneficiaries can take the full benefit (amount saved in the RA) as a lump sum or an annuity (income or pension).
If the benefit is taken as an annuity, the income is taxed at the recipient’s marginal rate of income tax.
If the benefit is taken as a lump sum, the amount is deemed to have accrued to the deceased fund member on the day before his or her death, and it is taxed in the hands of the deceased as if the member had retired from the fund. As a result, the first R500 000 is tax-free, an amount between R500 001 and R700 000 is taxed at 18 percent, an amount between R700 001 and R1 050 000 is taxed at 27 percent, and any amount over R1 050 001 is taxed at 36 percent.
Gordon says there are many reasons to use RAs as an estate-planning tool. These include:
* Savings in an RA do not form part of your estate if you are declared insolvent and they are largely protected from your creditors, because there are only limited circumstances in which deductions can be made from your RA savings.
Most small business owners consider their business to be their retirement plan without considering the risks of placing all their eggs in one precarious basket. Over-funding an RA might be a good long-term retirement strategy.
* You must use at least two-thirds of the benefits of an RA to buy either a living annuity or a guaranteed annuity.
An advantage of a living annuity over other income-producing investments is that the investment growth is not subject to tax; tax is payable only on the income.
Retirees who want to buy, or top up, a living annuity must first inject the capital into an RA fund, Gordon says.
On the pensioner’s death, a beneficiary has the choice of taking any residual capital in the living annuity in cash or buying an annuity, or a combination of both. If an annuity is purchased, the beneficiary will pay tax only on the annuity payments.
There is no estate duty on savings in an RA, unless the deceased made contributions that did not qualify for a tax deduction, and the savings are not subject to capital gains tax.
* Income from a pension is included in your taxable income, against which you can claim a tax deduction for contributions to an RA. In addition, you can claim a refund of the tax paid on the income from a compulsory annuity to the extent of your after-tax contributions.
So, an after-tax lump sum injected into an RA has tax benefits for a person who is drawing an income from a living annuity or who wants to top up a living annuity, Gordon says.
If the lump-sum injections are fully deducted, or if the tax on the compulsory annuity income has been fully refunded by the time the person dies, there will be no estate duty on the lump sum.
On the other hand, if you put the lump sum in a discretionary investment, it could be liable for estate duty, depending on whether the assets in the estate that attract estate duty exceed the estate duty exemption.
CONTRIBUTION QUANDARY
You would have to know that you will die before January 1 next year if you wanted to ramp up your contributions to a retirement annuity (RA) fund to reduce your estate duty liability.
In response to the proposed changes to the tax-deductibility of contributions to RA funds, Personal Finance reader Keith Payne asked whether taxpayers can “load” their contributions above the tax-deductible limits for the rest of this tax year to take advantage of the exemption. Payne wanted to know whether he can pay large amounts into a RA this year, to put as much as possible into the fund before the estate duty loophole is closed.
Jenny Gordon, the head of retail legal support at Alexander Forbes, says the Taxation Laws Amendment Bill of 2015 makes it clear that if you die after January 1, 2016, any contribution to a retirement fund made from March 1 this year that exceeds the deductible limits will be subject to estate duty if it has still not been deducted or exempted by the time the contributor dies.
“So, although the draft bill is not yet law, as soon as it is enacted, all after-tax contributions made after March 1, 2015 that are not written off by the time the person dies will be included in the estate duty calculation if death occurs after January 1, 2016.
“The only window period will be in the unfortunate event of death prior to January 1, 2016. Because people generally cannot predict their date of death, there is no window of opportunity to over-contribute,” Gordon says.
The estate duty amendment in the Taxation Laws Amendment Bill applies to any contribution made after March 1, 2015 that was not deducted or exempted by the date of death where the person dies after January 1, 2016.
“It does not matter whether the beneficiary elects to take the death benefit as a cash lump sum or purchases an annuity. The determining factor is that the deceased retirement fund member paid an amount into the fund that did not qualify for a deduction or an exemption. That amount will be included in the estate of the deceased member for estate duty purposes,” Gordon says.