There is going to be heated debate in retirement planning circles as a result of the proposed amendment to implement annuitisation requirements on provident funds with effect from 1 March 2015. Matthew Lester, Professor of Taxation Studies at Rhodes Business School in Grahamstown and a member of the Davis Tax Committee, investigates the effect the change will have.
Don’t panic. National Treasury has observed the vested right of provident fund members to be exempt from the new requirements. Furthermore, members of provident funds who are older than 55 on 1 March 2015 will not be affected by the amendments.
But what if you are self-employed, or if your company’s retirement fund only allows you to allocate a proportion of your salary up to a specified maximum (for example, you would like to allocate 20% of your regular salary towards your retirement savings, but your company only allows you to allocate up to a maximum of 15% of your salary)? In this case, a retirement annuity (RA) could be the answer.
Types of funds
There are three basic types of retirement funds in the South African retirement system: pension funds, provident funds and retirement annuity funds.
For individuals who change employers, there are preservation funds that hold retirement savings until retirement.
Contributions to retirement funds
Employer contributions to pension funds and provident funds are tax deductible up to certain limits. These amendments and the capping of retirement fund contributions have been covered in previous articles.
Payouts from retirement funds
Payouts from a retirement fund take the form of a lump sum or an annuity. A lump sum will be taxable according to the retirement tax tables contained in the second schedule while an annuity will be taxable at the recipient’s marginal tax rate.
Annuitisation
Pension and retirement annuity fund members are already bound by a mandatory annuitisation requirement that requires the members to annuitise at least two-thirds of their fund interests upon retirement.
However, provident funds currently enjoy the advantage in that members are not required to annuitise any portion of fund savings. Most provident fund members choose to receive their retirement interests as a lump sum upon retirement.
A de minimis exception overrides the mandatory two-thirds annuitisation requirement if the member’s fund is less than R75 000 at retirement.
Preservation funds allow individuals to preserve their retirement savings when changing employers. Pension preservation and provident preservation funds cannot accept contributions from members; these funds can only accept transfers from (employer-provided) pension and provident funds. In general, no tax is levied on the transfer of retirement savings from one fund to another.
However, due to the lack of annuitisation requirements in provident and provident preservation funds, transfers of retirement savings to those funds are taxed.
The absence of mandatory annuitisation in provident funds means that many retirees spend their retirement assets too quickly and face the risk of outliving their retirement savings.
The new annuitisation rule: effective 1 March 2015
From 1 March 2015, any person retiring from a provident fund or provident preservation fund cannot receive a lump sum upon retirement of more than one-third of their retirement interests. A compulsory annuity will now be required for the remaining two-thirds of their retirement interests. There will, however, be protection of historic vested rights within a provident fund.
However, to protect existing vested interests:
- balances in provident funds as at 1 March 2015 (and any subsequent growth thereon) need not be annuitised;
- if a provident fund member is older than 55 years of age as at 1 March 2015, the mandatory annuitisation requirements will not apply to contributions to the fund together with any growth thereon, made by that person as a member of the fund, as at the effective date.
Provident funds will maintain separate accounts in respect of a member under the age of 55 as at 1 March 2015 (in order to separate pre- and post-1 March 2015 contributions together with related growth).
Separate accounts need not be maintained by a provident fund for:
- members over age 55 as at 1 March 2015 as no annuitisation is required; and
- members joining a provident fund on or after 1 March 2015 as full annuitisation is required.
Example 1:
Provident fund member older than age 55 on 1 March 2015
Facts
Member T of the United Provident Fund is 56 years old on 1 March 2015, at which time Member T’s fund interest is R400 000. Member T continues to contribute to the provident fund and retires at age 64. On that day, Member T’s retirement interest is R750 000.
Result
Member T will be able to take the entire amount as a lump sum at retirement (as under pre-existing law). The provident fund need not keep split accounts for Member T.
Example 2
Provident fund member younger than age 55 on 1 March 2015
Facts
Member W of Open Provident Fund is 54 years old on 1 March 2015, at which time Member W’s fund interest is R450 000 with this amount increasing by R150 000 by the year 2020. Member W also continues to pay R200 000 in contributions to the fund after 1 March 2015 until 2020 with related growth amounting to R50 000. The final retirement interest in 2020 is R850 000.
Fund administration
Open Provident Fund must maintain two separate accounts for Member W. One account in respect of the pre-1 March 2015 contributions and any growth thereon (R450 000 + R150 000), and another account in respect of the post-1 March 2015 contributions and related growth (R200 000 + R50 000).
Result
The pre-1 March 2015 contributions plus any growth thereon (R450 000 + R150 000 = R600 000) can be freely withdrawn as a lump sum.
The remaining R250 000 is subject to mandatory annuitisation. Member W may only take one-third of the R250 000 as a lump sum, while the remaining two-thirds is subject to annuitisation.
Protection principles will apply irrespective of whether the retirement interest remains in the provident fund or whether the retirement interest is transferred to another retirement or preservation fund.
If a provident fund member wants to transfer the member’s retirement interest to another retirement or preservation fund, the provident fund must be in a position to inform the transferee fund of the split of the fund interest between the value that remains subject to annuitisation and the value that continues to enjoy vested right protection.
Example: Provident fund member transfers to new fund
Facts
Person S, a member of Investment Provident Fund, is 29 years old on 1 March 2015, at which time the fund interest is R1 000 000. Person S continues to contribute to the provident fund. Six years later, Person S resigns. At this point, the R1 000 000 has grown to R2 000 000. The new contributions that Person S made to the Investment Provident Fund (and the growth thereon) amounts to R500 000. Person S transfers this R2 500 000 balance to a preservation fund. When Person S turns 70, Person S resigns from the preservation fund with a retirement interest of R10 000 000. The pre-1 March account of R2 000 000 grew to R8 500 000, and the subsequent amount of R500 000 grew to R1 500 000.
Administration
Investment Provident Fund must maintain an account for Person S in respect of the fund interest of R1 000 000 as at 1 March 2015 and any growth thereon (R1 000 000). Investment Provident Fund must also maintain a separate account for any contributions made after 1 March 2015 and any growth thereon (totaling R500 000).
When Person S transfers these amounts to the preservation fund, Investment Provident Fund must provide the preservation fund with a split of fund interests with one account falling within annuitisation (R500 000) and the other enjoying vested right protection (R2 000 000).
Preservation fund
The preservation fund must keep separate accounts for Person S. One account must exist in respect of the fund interest of R2 000 000 that continues to enjoy vested right protection and any growth thereon (R6 500 000). A separate account is required for the R500 000 that remains subject to annuitisation and any growth thereon (R1 000 000).
Result
The pre-1 March 2015 contributions plus growth thereon (that is, R8 500 000) will remain free from annuitisation. The newer amounts (of R1 500 000) will become subject to the new dispensation. Member W may only take one-third of the R1 500 000 as a lump sum while the remainder is subject to annuitisation.
De minimis exception
As a result of the amendment, the current threshold for the de minimis exception (R75 000) will be doubled to R150 000 for all retirement funds. As a result, every member may receive their entire retirement interest in the form of a lump sum as long as the portion of the member’s retirement interest that is possibly subject to mandatory annuitisation (that is, the two-thirds amount) does not exceed R150 000.
Example: De minimis exception
Facts
Member T of Consolidated Provident Fund retires at 60 years of age. Member T was 48 years old on 1 March 2015, at which time Member T’s fund interest was R450 000, which increases to R600 000 upon Member T’s retirement.
Prior to retirement, Member T contributed R80 000 to Consolidated Provident Fund after 1 March 2015 with growth of R40 000. The final retirement interest was R720 000.
Result
The pre-1 March 2015 amount plus growth (that is, R600 000) thereon is free from annuitisation. The remaining (R120 000) amount is potentially subject to mandatory annuitisation but for the de minimis threshold (R150 000). Member T can accordingly receive the entire R720 000 in the form of a lump sum.
The transfer of retirement savings to provident and provident preservation funds from other funds will be exempt from tax.
Commentary
Following the amendment to the rules relating to tax deductible retirement fund contributions, effective 1 March 2014, it was inevitable that National Treasury would implement the compulsory annuitisation amendment. It is indeed fortunate that provident fund investments prior to 1 March 2015 and members over 55 on 1 March 2015 will be exempt from the amendment.
The knee-jerk reaction from many will be that they would rather move to privately held investments if they can no longer withdraw 100% of their provident fund benefits. This requires far more in-depth analysis.
Retirement funds remain the only legal means of creating a tax-deductible retirement plan. This must be coupled with the other benefits of retirement funds, including tax-free growth within the retirement fund and estate duty exemption in respect of death benefits paid by a retirement fund.
The tax-free lump sum schedules contained in the second schedule to the income tax act have not been substantially adjusted since 2007. A tax-free lump sum of R315 000 or even R630 000 taxed at an average rate of 9% is simply insufficient in the context of a retirement plan. The tax rates imposed on lump sum benefits above R630 000 are prohibitive, as high as 36%. Most taxpayers in retirement would achieve a lower marginal tax rate by electing to receive an annuity. The days of basing a retirement plan on a 100% withdrawal of benefits from a retirement fund were over before the amendment reached parliament.
In most instances the taxpayer will still enjoy tax-efficient lump sums on retirement by simply drawing down one-third of the accumulated retirement benefit. The modern tax efficient retirement plan concentrates on retaining retirement capital within the tax haven of the retirement fund. Withdrawal benefits are limited through the use of the living annuity principle, to both contain tax exposure and allow the retirement capital to grow in a tax-free environment.
The living annuity principle is also far more tax-efficient when it comes to medical expenses incurred in retirement. Taxable income created by the annuity is offset against the medical rebate system. This principle cannot be achieved when pursuing the lump sum alternative.
Defined benefit pension funds have been phased out by many employers. This effectively leaves the choice for most taxpayers between provident funds and retirement annuity funds. The administrative costs of many provident funds exceed that of retirement annuity funds. Pension and provident funds provided by employers have possibly become outdated as the modern career seldom spans 40 years with the same employer. Now that the tax deduction on contribution is the same, irrespective of fund choice, the responsible employee is in the position to build up a suite of retirement annuity investments without being dependent on the employer. This inherently makes almost inevitable career-changing decisions far easier.
In short, the amendment is not as horrific as it would seem. It simply follows the evolution of retirement planning from the pursuit of the lump sum principle to the active management of the living annuity principle.
Source: The explanatory memorandum to the 2013 Income Tax Bill, October 2013
