New tax deduction rules for contributions to retirement funds

It has always been easy to set examinations designed to fail Tax 101 students – just test the tax deductions on employer and employee contributions to pension, provident and retirement annuity funds.

Each type of retirement fund has its own tax deduction rules. All it takes is a taxpayer invested in multiple retirement funds and the chaos is complete.

The Status Quo until 28 February 2014

Pension and Provident Funds

Tax-free employer contributions to pension funds are limited to 10% of employment income. However, SARS applies a discretionary allowance to increase tax-deductible contribution rates of up to 20% of employment income.

Tax-deductible employee contributions to pension funds are permitted to the extent of 7,5% of taxable income. Employee contributions to provident funds are not tax deductible.

Retirement annuity funds

Tax deductible contributions to retirement annuity funds are limited to individuals only and are limited to the greater of

  • R1 750 per annum, or
  • R3 500 of pension fund contributions, or
  • 15% of non-retirement funding income (NRFI).

Employer contributions to retirement annuity funds are treated as a fringe benefit, generally leaving the employee to claim the tax relief on submission of the tax return.

The result

Traditionally most employers provide a pension or provident fund for their employees as the tax profile of contribution, in the context of the employed taxpayer, is superior. Over the past 20 years this has created unintended consequences:

  • The traditional defined benefit pension fund has become unsustainable, as life expectancy has increased.
  • The employee’s career decisions have been substantially affected by the severe implications of premature resignation from defined benefit pension funds.

The above has caused many employers to move away from the defined benefit pension fund towards the provident fund.

However, this has created other problems:

  • Many have found adverse cost implications in maintaining provident funds.
  • Despite the extremely expensive tax implications, employees, when desperate for cash, have been known to resign or even divorce simply to access their retirement capital.

The above problems, and others, have been the subject of various National Treasury discussion papers over the past two years.

The first concrete moves towards reform are now contained in the draft Taxation Laws Amendment Bill. Parliamentary hearings will follow prior to the release of the bill (around October 2013) and the promulgation of the Taxation Laws Amendment Act (around January 2014.) However the proposed principles are highly unlikely to be changed and will, in all probability, come into effect on 1 March 2014.

The new regime for tax deduction on contributions to retirement funds 

If the proposals in the draft Tax Amendment Bill are anything to go by, South Africa should have a far simpler system for claiming income tax deductions on contributions to retirement funds.

The logic behind the new system is to treat all contributions to pension, provident and retirement annuity funds as a deductible employment expense for the employer and taxable fringe benefit for the employee. This leaves the employer in a tax neutral position.

Fringe benefits in respect of the employer contributions are exempt from employees’ tax deductions, subject to limitations.

Instead of creating different tax deduction rules for different funds, the new system grants an overall tax deduction to the individual taxpayer encompassing all contributions to retirement funds. This neutralises the fringe benefits tax on reasonable contribution levels.

Finally, there is a limitation on the tax-deductible contribution to the individual taxpayer. This has three components:

  • The limitation is calculated with reference to ‘taxable income’. This is a substantial change as all income is taken into account in determining the tax deduction in respect of contributions to all funds. In the past tax deductions for pension and provident fund contributions were limited to employment income.
  • In order to encourage higher levels of contribution, the tax deduction contribution ceiling has been increased to 27,5% of taxable income, regardless of the age of the taxpayer. This is far higher than the 15% contribution ceiling that is currently applied to retirement annuity funds.
  • An overall cap limits the tax deduction to a maximum R350 000 per annum, regardless of the taxpayer’s age. This is a far higher level than initially proposed. Only taxpayers with an income exceeding R1,27 million are potentially affected. However, to soften the blow, any disallowed contributions are carried forward and are potentially deductible in a subsequent year of assessment.

Questions and answers

What is the greatest benefit of the new system?
The new order will be of substantial benefit to self-employed taxpayers who do not have ready access to pension and provident funds, thus limiting their tax-deductible contributions to retirement annuity funds only. Currently these contributions are capped at 15% of non-retirement-funding-income. This will increase to 27,5% of taxable income.

Taxpayers with substantial investment and annuity income also stand to benefit from the higher contribution level of 27,5%.

Does the employed taxpayer benefit?
Currently it is only possible to create a tax efficient contribution level of 27,5% using a pension fund, (coupling an employer contribution of 20% and an employee contribution of 7,5%).

Tax efficient contributions to provident funds are currently limited to 20% of employment income. This will increase to 27,5% of taxable income.

Finally the employee’s contribution level is sometimes limited to below 27,5% by the employment contract or fund rules. In the future, additional contributions to the 27,5% level can be achieved through the use of retirement annuity fund contributions.

What about the 27,5% cap? What if a higher contribution level is required?
As stated above, the 27,5% contribution level only becomes capped where the taxpayer’s taxable income exceeds R1,27 million. There are about 60 000 taxpayers who are potentially subject to this limit.

The carry over of disallowed retirement fund contributions means tax relief will ultimately result in a subsequent year of assessment or on withdrawal from the retirement fund. This must certainly be viewed as a ‘consolation prize’.

However, one must not lose site of the total tax exemption granted to growth within the retirement fund. Even if the contribution is disallowed, the tax-free return on investment is a substantial benefit.

There is also the issue of diversity of investments. If a tax deduction is not available through a retirement fund, tax efficiency can still be achieved through other means such as partially taxable capital gains income, endowment policies etc.

How does one determine the optimum level of contribution?
February is going to become an extremely busy month for financial advisers. Taxpayers wishing to make full use of the 27,5% contribution ceilings will have to be assisted in forecasting their taxable income prior to tax year-end so that contributions can be adjusted.

Pension, provident or retirement annuity fund?
There can be no doubt that the retirement annuity fund has received a substantial boost from the new system, as previously contribution levels were limited to 15% of non-retirement funding income ‘NRFI.’

The distinct advantage of the new system is that it allows the taxpayer to develop a private retirement funding portfolio that is not affected by career choice, tax deductions or employer fund rules.

What about the provident fund?
The provident fund remains the optimum choice where the taxpayer is intent on withdrawing the entire accumulated capital in one lump sum on retirement. However, other factors must be also considered:

  • Many provident funds have become expensive to administer.
  • The tax profile of a provident fund withdrawal can become incredibly expensive (36%) where the lump sum exceeds R945 000. The taxpayer would probably do better by way of withdrawal by applying the living annuity principle.
  • The taxpayer loses the tax sanctuary offered by the retirement fund after withdrawal of the lump sum.
  • National Treasury is extremely concerned about the large number of South Africans who have exhausted their provident fund capital shortly after retirement. Forced preservation of retirement capital is currently under consideration and may be phased in at some stage in the future.

Are there other factors to be considered?
The tax efficiency on contributions and growth through a retirement fund has already been discussed. But what about the taxation consequences on withdrawal from a retirement fund? Some say that this is the ‘sting in the tail of retirement funds.’

Yes, the withdrawal benefits are taxable. However:

  • The tax rate applied to the annuity component is probably far below the tax rate applicable on contribution.
  • The second schedule tax concessions on lump sum withdrawals are generous:
    • Up to R315 000 – Tax free
    • R315 001 to R630 000 – 18%
    • R630 001 to R945 000 – 27%
  • Taxpayers over 65 years old are effectively able to negate much, if not all, of the taxation component applicable to an annuity, where the annuity is applied to pay medical expenses.
  • Death benefits paid from a retirement fund are exempt from capital gains tax and estate duty.

For most South Africans the new tax deduction system for retirement funds is good news. A small minority will be subject to the overall capping level of R350 000.

In order to maximise the benefits of the new system taxpayers will have to assess their optimum contributions on an annual basis and play a far more active part in their retirement planning.

This article originally appeared in New tax deduction rules for contributions to retirement funds in glacier by Sanlam, The {Inside} Story

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