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YOUR RETIREMENT FUND: WHAT IS IT REALLY WORTH?

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The Revenue Laws Amendment Bill, 2008 (the Bill) introduced an amendment to the Income tax Act No.58 of 1962 (the Act) in respect of the taxation of pre-retirement withdrawals from retirement funds (SARS, 2008:4). Pre-retirement withdrawal benefits are payable to fund members when they exit the fund prior to retirement or involve payments before termination of membership.

This paper aims at providing a brief overview of the current and proposed legislation as well as a practical illustration of the effect of the current and proposed legislation.

Current legislation

Currently the Act provides for R1 800 of any withdrawal benefit to be exempt from normal taxation (SARS 2008:4). The remaining portion of the lump sum is taxed based on the rating formula of section 5(10) of the Act. This section is also referred to as the averaging section, as it provides for tax to be calculated based on the highest average annual tax rate of the retirement year or the previous year of assessment.

The amount of R1 800 is applied to each year of assessment and not to each lump sum, should more than one fund pay out a withdrawal lump sum in one year of assessment. Consequently, the tax-free portion of R1 800 can be applied each year where a lump sum is paid as a result of withdrawal from a fund. However, paragraph 6 of the Second Schedule of the Act provides for a minimum tax-free portion of the benefit upon withdrawal. This paragraph was amended from 1 March 2006 and results in the tax-free portion (R1 800) being not less than the lesser of:

•  the total value of all withdrawal benefits, or

•  the sum of the taxpayer’s own contributions to the fund, not allowed as a deduction (Silke 2008:335).

Proposed legislation

The Bill provides that the tax-free portion of pre-retirement withdrawal benefits be R22 500. Any excess over R22 500 will be taxed according to a separate tax table, which will be included in tax legislation in 2009, while no rebate will be set off against the tax calculated on the lump sum (National Treasury, 2008:6). Therefore, the taxable portion of the lump sum received will be ‘ring-fenced’ and taxed separately in accordance with the following table: see Table 1 below.

Table 1

Lump sum: pre-retirement

Tax liability
R0 – R22 5000%
R22 501 – R600 00018%
R600 001 – R900 000R103 950 + 27% of the amount exceeding R600 001
R900 001 –R184 950 + 36% of the amount exceeding R900 001

 

This amendment also causes the calculation of normal tax to be simplified, as it eliminates the use of the section 5(10) rating formula. This rating formula is a complex calculation and depends on information that is not generally readily available to the taxpayer or the retirement fund (Tax Brief 2008:1).

Practical illustration

In order to illustrate the effect of both the current and the proposed legislation, an example is provided. For simplicity, all amounts are rounded to the nearest Rand.

Mr. X (50 years old) withdraws (prior to retirement) from a pension fund on 29 February 2008. He receives a lump sum of R300 000 as a result of the withdrawal. Mr. X belonged to the pension fund for 20 years and contributed a percentage of his cash salary throughout this period. Two scenarios are considered. In the first scenario Mr. X contributes 8 percent of his cash salary to the pension fund. In the second scenario he contributes 7.5 percent. In terms of section 11(k) of the Act, a taxpayer may deduct current pension fund contributions limited to a maximum of 7.5 percent of his retirement funding employment (Silke 2008:262). In the case of Mr. X retirement funding employment is his cash salary. His salary was adjusted annually on 1 March. Under both scenarios Mr. X does not transfer any portion of his withdrawal benefit to a qualifying fund. The following table provides information for the 20-year period: see Table 2 below.

Table 2

Year of assessment

Cash salary per annum

Contribution per annum at 8%

S.11(k) deduction limited to 7.5%

Non-deductible portion of contribution

1989

72 000

5 760

5 400

360

1990

79 200

6 336

5 940

396

1991

87 120

6 970

6 534

436

1992

95 832

7 667

7 187

480

1993

105 415

8 433

7 906

527

1994

115 957

9 277

8 670

607

1995

127 552

10 204

9 566

635

1996

140 308

11 225

10 523

702

1997

154 338

12 347

11 575

772

1998

169 772

13 582

12 733

849

1999

186 750

14 940

14 006

934

2000

205 424

16 434

15 407

1 027

2001

225 967

18 077

16 948

1 129

2002

248 563

19 885

18 642

1 243

2003

273 420

21 874

20 507

1 367

2004

300 762

24 061

22 557

1 504

2005

330 838

26 467

24 813

1 654

2006

363  922

29 114

27 294

1 820

2007

400 314

32 025

30 024

2 001

2008

440 345

35 228

33 026

2 203

TOTAL

20 646

 

Scenario 1 (Mr. X contributes 8 percent of his cash salary to the fund and consequently has a portion of his contributions disallowed):

Position under current legislation

His situation in the 2007 year of assessment is the following:

Salary                                                                                400 314

Less: section 11(k)                                                                           (30 024)

Taxable income                                                                370 290

Tax thereon:

R79 000 + 38% of the amount exceeding R300 000

(PKF 2008:5)                                                                    105 710

Less: Primary rebate (Silke 2008:259)                                            ( 7 200)

Normal tax for the year                                                      98 510

Average tax rate: 105 710/370 290 x 100 = 28.5%.

This amount is taxed using the rating formula contained in section 5(10) (Silke 2008:319). This rating formula considers the average rate of taxation of the previous year of assessment and the average tax rate in the current year of assessment. On the assumption that Mr. X only received the salary and could only deduct a section 11(k) deduction for the pension fund contribution, the calculation of his normal tax liability for the 2008 year of assessment would be:

Lump sum received                                                          300 000

Less:

R1 800, but this may not be less than the lesser of the total value of all withdrawal benefits (R300 000) or the sum of all contributions not allowed as a deduction (R20 646).      (20 646)

Included in gross income                                                  279 354

Taxable portion of lump sum                                            279 354

Salary                                                                                440 345

Gross income                                                                   719 699

Less: Section 11(k)                                                                          (33 026)

Taxable income                                                                686 673

Tax (Y) according to section 5(10):

Y = {A/[B+D-(C+L)] x (B-L)} + (LxR)

A = normal tax on [B+D-(C+L)]                                        114 906

B = taxable income                                                           686 673

C = benefits from rescue team or farming                                  0

D = retirement annuity contributions on lump sum                     0

L = lump sum benefit from fund                                       279 354

R = greater of average tax rate for the current

or the previous year

R, for the 2008 year = 114 906/389 319 = 29.9%                           29.9%

R, for the 2007 year = 105 710/370 290 = 28.5%

Therefore:

Y = [114 906/(686 673 – 279 354) x (686 673 – 279 354)] +

(279 354 x 29.9%)

Y = 114 906 + 83 527

Y =                                                                                    198 433

Less: Primary rebate (Silke 2008:259)                                            (  7 740)

Normal tax for the year                                                    190 693

Position under proposed legislation

To facilitate comparability the 2008 tax table and rebate is applied to the proposed legislation.

The calculation of Mr. X’s normal tax liability for the 2008 year of assessment would be:

Salary                                                                                440 345

Less: Section 11(k)                                                                          (33 026)

Taxable income                                                                407 319

Tax thereon:

R93 125 + 38% of the amount exceeding R350 000 (PKF 2008:5)                                                                                                        114 906

Less: Primary rebate                                                        (  7 740)

Normal tax (part 1)                                                           107 166

Lump sum received                                                          300 000

Less: exempt portion                                                        (22 500)

Taxable portion of lump sum                                            277 500

Tax thereon: 18% x 277 500 (part 2)                                  49 950

Summary

Normal tax under current legislation                                 190 693

Normal tax under proposed legislation (part 1 + part 2)   157 116

This example illustrates that the proposed legislation will be beneficial to the taxpayer to the extent of R190 693 less

R157 116, an amount equal to R33 577.

Scenario 2 (Mr. X contributes 7.5 percent of his cash salary to the fund and consequently has no disallowed portion in terms of section 11(k)):

The taxable portion of the lump sum is calculated as follows:

Lump sum received                                                          300 000

Less: R1 800, but this may not be less than the lesser of the total value of all withdrawal benefits (R300 000) or the sum of all contributions not allowed as a deduction (RNil). ( 1 800)

Included in gross income                                                  298 200

The calculation of his normal tax liability for the 2008 year of assessment would be:

Taxable portion of lump sum                                            298 200

Salary                                                                                440 345

Gross income                                                                   738 545

Less: Section 11(k)                                                                          (33 026)

Taxable income                                                                705 519

Tax (Y) according to section 5(10):

Y = {A/[B+D-(C+L)] x (B-L)} + (LxR)

A = normal tax on [B+D-(C+L)]                                        114 906

B = taxable income                                                           705 519

C = benefits from rescue team or farming                                  0

D = retirement annuity contributions on lump sum                     0

L = lump sum benefit from fund                                       298 200

R = greater of average tax rate for the current

or the previous year

R, for the 2008 year = 114 906/407 319 = 28.2%                           28.5%

R, for the 2007 year = 105 710/370 290 = 28.5%

Therefore:

Y = [114906/(705 519 – 298 200) x (705 519 – 298 200)] +

(298 200 x 28.5%)

Y = 114 906 + 84 987

Y =                                                                                    199 893

Less: Primary rebate                                                        (  7 740)

Normal tax for the year                                                    192 153

Summary

Normal tax under current legislation                                 192 153

Normal tax under proposed legislation                             157 116

In this scenario the taxpayer again benefits from the proposed legislation by an amount of R192 153 less R157 116, equal to R35 037.

Conclusion

This paper serves to provide a practical illustration of the effect of the current and proposed tax legislation on withdrawal benefits from retirement funds. It shows that the proposed legislation is indeed beneficial to the taxpayer. In addition, it also simplifies the calculation of the normal tax liability for the taxpayer, as it eliminates the use of the somewhat complex section 5(10) rating formula.

References

1.  National Treasury 2008. www.treasury.gov.za. Explanatory memorandum on the Revenue Laws Amendment Bill, 2008 (Submitted to the Portfolio Committee on Finance

22 October 2008).

2.  PKF 2008. Tax Guide 2008/2009.

3.  Silke on South African Income Tax 2008.

4.  South African Revenue Services (SARS) 2008.

www.sars.gov.za. Draft explanatory memorandum on the Revenue Laws Amendment Bill, 2008.

Ellané van Wyk CA(SA), MAcc is a tax lecturer at the University of Stellenbosch.

This paper aims at providing a brief overview of the current and proposed legislation as well as a practical illustration of the effect of the current and proposed legislation.

 

Current legislation

Currently the Act provides for R1 800 of any withdrawal benefit to be exempt from normal taxation (SARS 2008:4). The remaining portion of the lump sum is taxed based on the rating formula of section 5(10) of the Act. This section is also referred to as the averaging section, as it provides for tax to be calculated based on the highest average annual tax rate of the retirement year or the previous year of assessment.

 

The amount of R1 800 is applied to each year of assessment and not to each lump sum, should more than one fund pay out a withdrawal lump sum in one year of assessment. Consequently, the tax-free portion of R1 800 can be applied each year where a lump sum is paid as a result of withdrawal from a fund. However, paragraph 6 of the Second Schedule of the Act provides for a minimum tax-free portion of the benefit upon withdrawal. This paragraph was amended from 1 March 2006 and results in the tax-free portion (R1 800) being not less than the lesser of:

 

  • the total value of all withdrawal benefits, or
  • the sum of the taxpayer’s own contributions to the fund, not allowed as a deduction (Silke 2008:335).

 

Proposed legislation

The Bill provides that the tax-free portion of pre-retirement withdrawal benefits be R22 500. Any excess over R22 500 will be taxed according to a separate tax table, which will be included in tax legislation in 2009, while no rebate will be set off against the tax calculated on the lump sum (National Treasury, 2008:6). Therefore, the taxable portion of the lump sum received will be ‘ring-fenced’ and taxed separately in accordance with the following table: see Table 1 below.

 

Table 1

Lump sum: pre-retirement

 

Tax liability

 

R0 – R22 500

 

0%

 

R22 501 – R600 000

 

18%

 

R600 001 – R900 000

 

R103 950 + 27% of the amount exceeding R600 001

 

R900 001 –

 

R184 950 + 36% of the amount exceeding R900 001

 

 

This amendment also causes the calculation of normal tax to be simplified, as it eliminates the use of the section 5(10) rating formula. This rating formula is a complex calculation and depends on information that is not generally readily available to the taxpayer or the retirement fund (Tax Brief 2008:1).

 

Practical illustration

In order to illustrate the effect of both the current and the proposed legislation, an example is provided. For simplicity, all amounts are rounded to the nearest Rand.

 

Mr. X (50 years old) withdraws (prior to retirement) from a pension fund on 29 February 2008. He receives a lump sum of R300 000 as a result of the withdrawal. Mr. X belonged to the pension fund for 20 years and contributed a percentage of his cash salary throughout this period. Two scenarios are considered. In the first scenario Mr. X contributes 8 percent of his cash salary to the pension fund. In the second scenario he contributes 7.5 percent. In terms of section 11(k) of the Act, a taxpayer may deduct current pension fund contributions limited to a maximum of 7.5 percent of his retirement funding employment (Silke 2008:262). In the case of Mr. X retirement funding employment is his cash salary. His salary was adjusted annually on 1 March. Under both scenarios Mr. X does not transfer any portion of his withdrawal benefit to a qualifying fund. The following table provides information for the 20-year period: see Table 2 below.

 

Table 2

Year of assessment

 

Cash salary per annum

 

Contribution per annum at 8%

 

S.11(k) deduction limited to 7.5%

 

Non-deductible portion of contribution

 

1989

 

72 000

 

5 760

 

5 400

 

360

 

1990

 

79 200

 

6 336

 

5 940

 

396

 

1991

 

87 120

 

6 970

 

6 534

 

436

 

1992

 

95 832

 

7 667

 

7 187

 

480

 

1993

 

105 415

 

8 433

 

7 906

 

527

 

1994

 

115 957

 

9 277

 

8 670

 

607

 

1995

 

127 552

 

10 204

 

9 566

 

635

 

1996

 

140 308

 

11 225

 

10 523

 

702

 

1997

 

154 338

 

12 347

 

11 575

 

772

 

1998

 

169 772

 

13 582

 

12 733

 

849

 

1999

 

186 750

 

14 940

 

14 006

 

934

 

2000

 

205 424

 

16 434

 

15 407

 

1 027

 

2001

 

225 967

 

18 077

 

16 948

 

1 129

 

2002

 

248 563

 

19 885

 

18 642

 

1 243

 

2003

 

273 420

 

21 874

 

20 507

 

1 367

 

2004

 

300 762

 

24 061

 

22 557

 

1 504

 

2005

 

330 838

 

26 467

 

24 813

 

1 654

 

2006

 

363  922

 

29 114

 

27 294

 

1 820

 

2007

 

400 314

 

32 025

 

30 024

 

2 001

 

2008

 

440 345

 

35 228

 

33 026

 

2 203

 

TOTAL

 

20 646

 

 

 

Scenario 1 (Mr. X contributes 8 percent of his cash salary to the fund and consequently has a portion of his contributions disallowed):

 

Position under current legislation

His situation in the 2007 year of assessment is the following:

 

Salary                                                                                400 314

Less: section 11(k)                                                                           (30 024)

Taxable income                                                                370 290

 

Tax thereon:

R79 000 + 38% of the amount exceeding R300 000
(PKF 2008:5)                                                                    105 710

Less: Primary rebate (Silke 2008:259)                                            ( 7 200)

Normal tax for the year                                                      98 510

Average tax rate: 105 710/370 290 x 100 = 28.5%.

 

This amount is taxed using the rating formula contained in section 5(10) (Silke 2008:319). This rating formula considers the average rate of taxation of the previous year of assessment and the average tax rate in the current year of assessment. On the assumption that Mr. X only received the salary and could only deduct a section 11(k) deduction for the pension fund contribution, the calculation of his normal tax liability for the 2008 year of assessment would be:

Lump sum received                                                          300 000

Less:

R1 800, but this may not be less than the lesser of the total value of all withdrawal benefits (R300 000) or the sum of all contributions not allowed as a deduction (R20 646).      (20 646)

Included in gross income                                                  279 354

Taxable portion of lump sum                                            279 354

Salary                                                                                440 345

Gross income                                                                   719 699

Less: Section 11(k)                                                                          (33 026)

Taxable income                                                                686 673

 

Tax (Y) according to section 5(10):

Y = {A/[B+D-(C+L)] x (B-L)} + (LxR)

A = normal tax on [B+D-(C+L)]                                        114 906

B = taxable income                                                           686 673

C = benefits from rescue team or farming                                  0

D = retirement annuity contributions on lump sum                     0

L = lump sum benefit from fund                                       279 354

R = greater of average tax rate for the current
or the previous year

R, for the 2008 year = 114 906/389 319 = 29.9%                           29.9%

R, for the 2007 year = 105 710/370 290 = 28.5%

Therefore:

Y = [114 906/(686 673 – 279 354) x (686 673 – 279 354)] +
(279 354 x 29.9%)

Y = 114 906 + 83 527

Y =                                                                                    198 433

Less: Primary rebate (Silke 2008:259)                                            (  7 740)

Normal tax for the year                                                    190 693

 

Position under proposed legislation

To facilitate comparability the 2008 tax table and rebate is applied to the proposed legislation.

The calculation of Mr. X’s normal tax liability for the 2008 year of assessment would be:

 

Salary                                                                                440 345

Less: Section 11(k)                                                                          (33 026)

Taxable income                                                                407 319

Tax thereon:

R93 125 + 38% of the amount exceeding R350 000 (PKF 2008:5)                                                                                                        114 906

Less: Primary rebate                                                        (  7 740)

Normal tax (part 1)                                                           107 166

 

Lump sum received                                                          300 000

Less: exempt portion                                                        (22 500)

Taxable portion of lump sum                                            277 500

 

Tax thereon: 18% x 277 500 (part 2)                                  49 950

 

Summary

Normal tax under current legislation                                 190 693

Normal tax under proposed legislation (part 1 + part 2)   157 116

 

This example illustrates that the proposed legislation will be beneficial to the taxpayer to the extent of R190 693 less
R157 116, an amount equal to R33 577.

 

Scenario 2 (Mr. X contributes 7.5 percent of his cash salary to the fund and consequently has no disallowed portion in terms of section 11(k)):

 

The taxable portion of the lump sum is calculated as follows:

 

Lump sum received                                                          300 000

Less: R1 800, but this may not be less than the lesser of the total value of all withdrawal benefits (R300 000) or the sum of all contributions not allowed as a deduction (RNil). ( 1 800)

Included in gross income                                                  298 200

 

The calculation of his normal tax liability for the 2008 year of assessment would be:

Taxable portion of lump sum                                            298 200

Salary                                                                                440 345

Gross income                                                                   738 545

Less: Section 11(k)                                                                          (33 026)

Taxable income                                                                705 519

Tax (Y) according to section 5(10):

Y = {A/[B+D-(C+L)] x (B-L)} + (LxR)

A = normal tax on [B+D-(C+L)]                                        114 906

B = taxable income                                                           705 519

C = benefits from rescue team or farming                                  0

D = retirement annuity contributions on lump sum                     0

L = lump sum benefit from fund                                       298 200

R = greater of average tax rate for the current
or the previous year

R, for the 2008 year = 114 906/407 319 = 28.2%                           28.5%

R, for the 2007 year = 105 710/370 290 = 28.5%

 

Therefore:

Y = [114906/(705 519 – 298 200) x (705 519 – 298 200)] +
(298 200 x 28.5%)

Y = 114 906 + 84 987

Y =                                                                                    199 893

Less: Primary rebate                                                        (  7 740)

Normal tax for the year                                                    192 153

 

Summary

Normal tax under current legislation                                 192 153

Normal tax under proposed legislation                             157 116

 

In this scenario the taxpayer again benefits from the proposed legislation by an amount of R192 153 less R157 116, equal to R35 037.

 

Conclusion

This paper serves to provide a practical illustration of the effect of the current and proposed tax legislation on withdrawal benefits from retirement funds. It shows that the proposed legislation is indeed beneficial to the taxpayer. In addition, it also simplifies the calculation of the normal tax liability for the taxpayer, as it eliminates the use of the somewhat complex section 5(10) rating formula.

 

References

  1. National Treasury 2008. www.treasury.gov.za. Explanatory memorandum on the Revenue Laws Amendment Bill, 2008 (Submitted to the Portfolio Committee on Finance
    22 October 2008).
  2. PKF 2008. Tax Guide 2008/2009.
  3. Silke on South African Income Tax 2008.
  4. South African Revenue Services (SARS) 2008.
    www.sars.gov.za. Draft explanatory memorandum on the Revenue Laws Amendment Bill, 2008.

 

Ellané van Wyk CA(SA), MAcc is a tax lecturer at the University of Stellenbosch.