The current rules governing the taxation of retirement funds provides for a legal tax avoidance scheme for the very wealthy to consider. This is why:
- Retirement funds pay no tax; that is no income, capital gain or dividend tax
- Non-tax deductible contributions are tax free at retirement
- Retirement funds are exempt from estate duty
The tax free status of retirements effectively results in a higher return on the underlying investment portfolio as a result of the tax savings. The only negative in respect of the underlying investment portfolio return is the requirement that the portfolio must comply with Prudential Investment Guidelines Reg 28, which limits share exposure to a maximum of 75% and offshore exposure to 25%.
Changes in respect of the rules for non-tax deductible contributions provide the real planning opportunity. Non-tax deductible contributions can be added to the tax free lumpsum benefit at retirement and / or carried forward and off-set against the monthly taxable pension from the retirement fund. This is best illustrated with an example using Joe Blogg. Joe is a wealth executive with an R 20 mil share portfolio, a house worth R 10 mil and a retirement fund projected to be worth R 12.5 mil at retirement.
He intends retiring next year and expects to earn an after tax bonus of R 3 mil for this year and the same next year. Joe would usually add the bonus to his share portfolio, which would then increase his total share portfolio to R 26 mil at retirement (ignoring any growth). The share portfolio will provide him with an annual dividend income of 3.5% or R 910 000, which is then liable for 15% DWT of R 136 500 netting him R 773 500 for the year. His retirement fund is worth R 12.5 mil and assuming he elects to draw only the tax free amount of R 500 000, this leaves R 12 mil to be invested in a living annuity to provide him with a 2.5% (minimum) pension of R 300 000 before tax and R 255 700 after tax. His total income is thus R 1029 190, which is adequate for his income requirements. In this scenario Joe’s assets will continue to grow, worsening his future estate duty tax liability, which is currently R 5.9 mil (20% on a dutiable estate of R29.5 mil, excludes the retirement fund and R 7 mil abatement).
Joe should consider, as a legal tax avoidance scheme, rather investing his annual bonus of R6 mil into a retirement annuity. He would then retire with an R 20 mil share portfolio providing dividend income of R 700 000 less tax = R 595 000 and a “tax free” pension income of R 450 000 (2.5% * R 18 mil retirement fund), total income of R 1045 000. The pension is tax free as a result of the non-tax deductible contribution to the RA of R 6 mil being carried forward and offset against the taxable pension income. For simplicity assuming the pension remains on R 450 000 this would provide tax free income for 13.3 years from the retirement fund. Joe’s estate duty liability is now also reduced to only R 4.7 mil (20% * R 23.5 mil, excludes retirement fund and R 7 mil abatement) and future growth in the retirement fund will remain duty free).
Now for the disclaimer, this is a very simplistic illustration for the purpose only of providing “food” for further thought. There are a myriad of considerations, which need to be taken into account before committing to a strategy like this, discuss with your certified financial planner.
Mcomm, CFP®, HdipTax
T. 021-851 3746