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Manage your tax affairs

Manage your tax affairs

A living annuity can have significant tax benefits for some individuals

By Elmie de Jager

22/2/2020

A few weeks ago, my colleague wrote about annuities and where it fits into one’s planning. When it comes to living annuities, people think of it as being the darker side of retirement annuities, where you will be taxed on the income for which you have received a tax deduction all those years before.

Living annuities, however, have some very interesting tax benefits for people who, after retirement, find themselves with two problems, namely high income tax on interest earned and estate duty.

If you understand section 10C of the Income Tax Act, and how it can be applied to your specific situation, a living annuity can be a very valuable arrow in your quiver to guard against the various wealth taxes that have appeared in recent years.

To revisit the rules of the estate duty: All assets in your personal name (including loan accounts between yourself and your trust) are subject to estate duty, except for the following:

  • All bequests to a surviving spouse are exempt from estate duty for as long as the spouse is alive.

Upon the death of each spouse, an exemption of R3,5 million is applied, which means that upon the death of the surviving spouse there is a combined estate duty exemption of R7 million.

All assets in the deceased’s estate over and above the combined exemption (R7 million up to R30 million) are subject to 20% estate duty. Above R30 million, the rate increases to 25%.

  • Upon death, funds invested in a retirement annuity (RA) are excluded from the calculation of estate duty.
  • Upon death, investments in a living annuity are excluded from the calculation of estate duty, but any previously disallowed contributions are added back.

What do I mean by “previously disallowed contributions”?

In any specific year, there is a limit on how much of your retirement saving contributions can be deducted for income tax purposes, but there is no limit on how much you may contribute. The absolute maximum permissible deduction is currently R350 000.

Any contributions over and above the maximum are known as disallowed contributions and these unused credits create a golden opportunity to improve the management of your tax affairs after retirement.

Let me explain the rules about section 10C using a practical example. See the accompanying table.

Assumptions: 8% growth, 100% of growth is in the form of interest income, current tax tables and exemptions are applied, the estate duty exemption of R3.5m per individual or R7m per couple has already been used, and the investor did not receive any other taxable income.

When you retire from a retirement annuity and start to withdraw an income from the living annuity, this income can be tax-free if, historically, your contributions to your retirement annuity were more than the maximum allowable contribution for tax purposes according to legislation at the time.

This concession in the Income Tax Act provides a great opportunity to significantly reduce your taxable estate after retirement while also earning a tax-free income, if appropriate for your financial plan.

The example shows a wealthy individual who has no need or appetite for risk and who invests R10 million in income funds from which he/she receives an income of R500 000 annually (which increases with 5% p.a). For the purpose of the exercise we assume an 8% annual growth rate on the investment.

Note the dramatically different outcomes after a period of 10 years:

  • In the example above, the owner of the living annuity reduced his/her previously disallowed contributions by means of a tax-free income from an initial amount of R10 million to R3 711 054 over a period of ten years.

If he dies at this stage, the taxable part of the initial R10 million investment will now be limited to only R3,7 million – what remains of the previously disallowed contributions.

In the case of a unit trust or fixed deposit in the client’s own name, the estate duty would be calculated on the balance of R9 674 348 instead of R3 711 054.

  • Upon the death of the client, his/her beneficiary(s) would have the option to either withdraw the amount in cash, or to continue receiving the income, or a combination of the two.

Points to note:

  • Even though the previously disallowed contributions have not been used during the life of the primary client, his/her beneficiaries will not be able to use the remaining section 10C credits to generate a tax-free income.
  • The beneficiaries would be able to take the R3,7 million in previously disallowed contributions as well as the current R500 000 tax-free amount (if not taken in the past) in cash without having to pay tax on it.

The balance (R7 802 146) will however be subject to retirement tax tables should the beneficiaries choose to withdraw the full amount.

In our opinion, the retirement tax would make it undesirable, in most cases, to withdraw more than the tax-exempt portion in cash. The balance will simply continue to provide an income to the beneficiaries, even though it is taxable.

  • Although the primary client mentioned above may withdraw a tax-free income, the monthly tax will initially be deducted, and the client will then have to claim it back from the South African Revenue Service annually.
  • You will not be able to take your living annuity with you should you decide to emigrate. The income needs to be paid out into a local bank account.
  • Despite the point mentioned above, you can at this stage still have 100% exposure to offshore assets should you choose to, as living annuities are not regulated by regulation 28 of the Pension Funds Act.

In conclusion: The above scenario illustrates once again the possible financial implications of decisions that are made, often without proper consideration.

Before you make any important decisions, make sure that you consult a professional adviser who will take your specific circumstances into account and consider the suitability of a solution to your financial plan.

Elmie de Jager is a certified financial planner at ProVérte Wealth & Risk Management. Email her at info@proverte.co.za.

Although all possible care was taken in the drafting of this document, the factual correctness of the information contained herein cannot be guaranteed. This document does not constitute advice and anyone planning on taking any financial action based on this document, is strongly advised to first consult with their personal financial advisor. ProVérte Wealth & Risk Management is an authorised financial service provider with FSP no. 5966.

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