Thank you very much for your question regarding overcontributions to an RA, or what is often referred to as disallowed contributions. We have answered these questions in accordance with the applicable acts that govern how these overcontributions are treated. Furthermore, we will refer to overcontributions as ‘disallowed contributions’ throughout for the sake of continuity.
At the outset, yes, you are correct that the proceeds of approved retirement funds can be added to a living annuity, even though this contribution contains “disallowed contributions” from previous tax years.
First, let’s address the income tax implications
The income drawn from a living annuity is taxable at the prevailing income tax rate of the annuitant. Keep in mind that a living annuity is a very tax-efficient structure, as all growth within the investment is free from capital gains tax, interest, and dividend tax.
With the above in mind, yes, you can continue contributing to your retirement funds throughout your lifetime, and your disallowed contributions can be utilised at retirement.
The below scenario provides further explanation:
- You are 55 or older and have a RA with an asset value of R3.6 million. R2.1 million of this value is made up of disallowed contributions that you have made over the past six years.
- At retirement, if you were to take a cash portion, the maximum permitted amount you can take is up to one-third of your retirement annuity value. The balance of the RA must be used to purchase a compulsory annuity (living annuity or life annuity). The taxable lump sum will be taxed according to the retirement tax tables, where the first R550 000 is tax-free (assuming you haven’t taken any cash portion from other retirement funds previously). In this particular example, your one-third taxable lump sum amounts to R1.2 million. Since your disallowed contributions will be used to reduce the taxable portion of the lump sum, the full cash portion will be tax-free.
- Now that you have taken the cash portion and purchased a compulsory annuity, you still have R900 000 as disallowed contributions. In terms of Section 10C of the Income Tax Act, you have a qualifying annuity that is exempt from tax to the extent of your own contributions to any pension, provident, or RA fund that was not deductible from income. This means that your compulsory annuity income will be entirely tax-free until the disallowed contribution is depleted. For example, if you purchased a living annuity and were to take 5% of your current living annuity amount (R2.4 million x 5%), equating to R120 000 per annum, your entire income for that year will be tax-exempt, and you will still have R780 000 as disallowed contributions to be utilised in the new year.
What are the estate duty implications of your disallowed contributions?
In terms of Section 3(2) of the Estate Duty Act 45 of 1955, your living annuity will fall outside of your deceased estate as long as you have nominated beneficiaries to receive the death benefit, either in the form of an annuity, cash or a combination of both. However, your disallowed contributions can only be excluded from the deceased estate if your nominated beneficiary or beneficiaries elect to take the full death benefit as an annuity.
Due to the amended Section 3(2)(b)(A) of the Estate Duty Act, disallowed contributions may be considered deemed property in your deceased estate and, therefore, subject to estate duty if your nominated beneficiary elects to take the proceeds in cash or elects to make a partial cash withdrawal while annuitising the balance. Note that the disallowed contributions for the cash portion will be included in your estate for estate duty calculations.
However, if your nominated beneficiary elects to take the benefit as an annuity in their name, the disallowed contributions will not be included in your deceased estate to calculate estate duty. Furthermore, the disallowed contributions will not be transferred to your beneficiaries, and the income they receive from this investment will be taxed in their hands, according to the prevailing income tax tables.