A retirement annuity is a very effective tax vehicle and estate duty shelter

● You are probably aware that there is a tax advantage to using a retirement annuity, but you may not be aware of the restrictions on these products and just how these stack up against the many benefits.

If so, take a look at this list of the advantages, the restrictions, and what they mean for you.

Advantages

Contributions to an RA are tax-deductible, subject to certain limits. The deduction is limited to 27.5% of your taxable income or remuneration, subject to an overall maximum cap of R350 000 a year. This overall limit applies to contributions to all retirement funds together.

There is no tax on any investment held inside an RA, as the RA is in a tax-free fund. This means that if you own investments in an RA, you avoid dividends tax, capital gains tax and any tax on interest on those investments. When you take your money out of the RA at retirement, you qualify for additional tax benefits. Although only a third of the fund can be taken in cash, that cash is taxed at lower than normal rates: R0R500 000 is taxed at 0%; R500 001-R700 000 at 18%; R700 001-R1 050 000 at 27%; and anything above R1 050 000 at 36%.

This “ring-fenced” or special rate applicable to retirement lump sums is generally lower than most taxpayers’ marginal rates, which can be as high as 45%. It is only when a lump sum of more than R1 050 000 is taken that the rate becomes high — 36%. A lump sum below R1 050 000 will be taxed at a maximum of 27%, which is a lot lower than the marginal rate. Note that these lower rates will be available only once in a lifetime.

On your death, the fund value in your RA can be paid out in full to your dependants. Although this lump sum would be taxable in your estate based on the retirement lump-sum tables, the fund value would generally be free of estate duty.

This is subject to certain complex exceptions such as when you made contributions to the RA which are not tax-deductible. In this way an RA is an effective estate duty shelter for most investors. Should you go insolvent, your RA is generally protected against creditors, again subject to certain complex exceptions such as lump sums being contributed when insolvency was pending.

On your death, the full fund value in an RA can be paid out to your dependants (as defined in the Pension Funds Act) directly, without going via your estate. This saves on executor’s fees and ensures that your dependants receive the proceeds without having to wait for your estate to be wound up.

Disadvantages

An RA cannot normally be accessed before the age of 55. The main exception is if you emigrate officially, informing the South African Reserve Bank, before 55. At 55, or later, on your chosen retirement age, you can generally draw only a third of the fund in cash, and must use the balance to buy an annuity. If the full fund value is less than R247 500 then it can be taken in full in cash.

Any contributions above 27.5% of your taxable income, or R350 000, are not taxdeductible and have to be carried forward to the following tax year. If they are still not deductible then, they will eventually be taxfree on retirement, thus increasing the taxfree lump sum you can take. However, any non-deductible amounts will be included in your estate on your death.

An RA is not protected on divorce. Your ex can claim against the retirement fund in terms of section 7 of the Divorce Act.

There are some limits on the investments you can make in an RA — these are in terms of regulation 28 of the Pension Funds Act.

Finally, and most important, section 37C of the act removes your freedom of testation in respect of any payout from a retirement fund on death, and obliges the trustees of the fund to pay the death benefit to your dependants, as may be deemed equitable, “to one of such dependants or in proportions to some of or all such dependants”.

The trustees therefore have a discretion to overrule any beneficiary nominations you make and to pay dependants as they deem equitable. As a member of an RA, therefore, you have no control over how the assets in the fund will be distributed on your death. Of course, the plus side is that normally these assets are paid out free of estate duty.

An RA is a very efficient tax and estate duty vehicle. However, you need to be aware of the limits on the tax-deductibility of contributions and on your access to your savings. You should also be aware that on your death you cannot control the distribution of the funds.

You should have a detailed discussion with your financial adviser to calculate how much of your contributions are tax-deductible and should be aware of the consequences of excess contributions. You must also understand that the savings you are building up are for retirement, and cannot be used before then.

An RA is one of the few ways to make an investment in unit trusts tax-deductible, but you should invest knowing all the issues.