In this article, Michael Summerton and Carla Rossouw provide an overview of how withdrawal and retirement benefits are taxed. They use practical examples to show how this tax is calculated. They illustrate how you can save tax by deferring your withdrawal until retirement. They also look at the tax relief Treasury provides on benefits received when a retirement fund member is retrenched.
Regular readers of our commentary will know that we encourage a long-term approach to investing. We especially encourage investors not to be tempted to dip into their retirement savings. Withdrawing funds from your retirement savings before you retire, not only reduces the tax-free amount available to you when you retire, but also causes the benefit that you take at retirement to be taxed at a higher rate. Therefore, by deferring withdrawals until you retire, you may reduce your total tax bill.
Making sense of your potential tax bill
There are two main categories of benefits that retirement funds pay members.
- Withdrawal benefits: Payable before retirement (for example if you resign or get divorced)
- Retirement benefits: Payable when you retire from the fund or upon your death
Before 1 October 2007, the tax on retirement and withdrawal benefits received from retirement funds (including pension, provident and retirement annuity funds) was determined by a complex ratings formula. This formula was simplified from 1 October 2007, with further changes coming into effect on 1 March 2009.
In terms of the latest provisions, your tax liability for retirement and withdrawal benefits is determined by 'special rate' tables. If you are a member of a retirement fund, you do not pay tax on the first R300 000 when you retire from the fund, or upon your death. However, if you withdraw cash before you retire, only the first R22 500 is tax free. In both instances, the tax- free amount is a 'once-in-a-lifetime' concession.
The 'special rate' tables take into account all withdrawal and retirement benefits you received or accrued on or after 1 October 2007. In other words, all the benefits you received on or after 1 October 2007 are added together to calculate how much tax you owe when you withdraw or retire from your retirement fund. (Refer to Example 3.)
Tax on withdrawal benefits
From 1 March 2009, all withdrawal benefits from a retirement fund are taxed according to the withdrawal benefit table (see Table 1).
Example 1
Mr A is a member of two pension funds. He resigns from his employer and decides to withdraw from one of his funds (as opposed to preserving his savings until retirement). Mr A receives a R250 000 withdrawal benefit from the fund. The tax he has to pay on the R250 000 is calculated as follows:
Step 1: Apply the withdrawal benefit table (Table 1) to the withdrawal amount:
Calculation: R0 + 18% x (R250 000 - R22 500)
Tax payable: R40 950
Using Table 1, Mr A need not pay any tax on the first R22 500 of the R250 000. The remaining R227 500 is taxed at a rate of 18%. Based on the above calculation, he must pay an amount of R40 950 on his withdrawal benefit.
Example 2
Mr A subsequently decides to withdraw R350 000 from his second pension fund. Using Table 1, the tax that he must pay on the subsequent R350 000 withdrawal benefit is calculated as follows:
Step 1: Add up the withdrawal benefits received.
Calculation: R250 000 + R350 000
Total withdrawal benefits: R600 000
Step 2: Apply the withdrawal benefit table (Table 1) to the full amount.
Calculation: R0 + 18% x (R600 000 - R22 500)
Tax payable: R103 950
Step 3: Subtract the tax Mr A had to pay on all withdrawal benefits he received prior to the withdrawal benefit of R350 000. We have already calculated this in Example 1 as being R40 950.
Calculation: R103 950 - R 40 950
Total tax payable: R63 000
Mr A must therefore pay a total of R63 000 in tax for his second withdrawal benefit.
Tax on retirement benefits
Retirement benefits are taxed according to the rates shown in Table 2.
You do not have to pay tax on the first R300 000 of your retirement benefit. As stated earlier, this is a once-off concession. This means that while your first-time retirement benefit of R300 000 is exempt from tax, any subsequent retirement benefits of R300 000 will be taxed at 18%, the rate applicable to the next band of the retirement benefit table.
Example 3
Mr A now decides to retire from his retirement fund and receives a retirement benefit of R100 000. Taking into account that he has already received two withdrawal benefits (see Examples 1 and 2), the tax he must pay on the R100 000 is calculated as follows:
Step1: Add up the retirement and withdrawal benefits Mr A received.
Calculation: R250 000 + R350 000 + R100 000
Total benefits: R700 000
Step 2: Apply the retirement benefit rate table (Table 2) to the full amount.
Calculation: R54 000 + 27% x (R700 000 - R600 000)
Calculation: R54 000 + R27 000
Tax payable: R81 000
Step 3: Add up the withdrawal benefits received before retirement (i.e. from Examples 1 and 2) and apply the amount to the retirement benefit table (Table 2).
Calculation: R250 000 + R350 000
Total benefits: R600 000
Calculation: R0 +18% x (R600 000 - R300 000)
Tax payable: R54 000
Step 4: To calculate the total tax payable on the retirement benefit of R100 000, subtract the tax payable in Step 2 from the tax payable in Step 3.
Calculation: R81 000 - R54 000
Total tax payable: R27 000
The R54 000 is not the actual tax paid on the previous withdrawal benefits, but rather the amount of tax Mr A would have paid on his withdrawal benefits had he postponed them until his retirement. The difference between the solutions in Step 2 and Step 3 (i.e. R27 000), is the actual tax payable on the R100 000 retirement benefit that Mr A received.
If Mr A had deferred his two withdrawals and taken the full R700 000 at retirement he would have saved R49 950 in tax as displayed in Table 4.
Retrenchment
Recent changes to the Income Tax Act (effective from 1 March 2010) mean that if you withdraw from your employer's retirement fund because you are retrenched, your withdrawal benefit will, in certain circumstances, be taxed in the same way as if you had retired from that fund.
The intention of the amendments is to treat the withdrawal benefit on retrenchment in the same way as a retirement benefit for tax purposes. The R300 000 exemption and aggregation principle apply.
These changes apply only to withdrawal benefits if you are retrenched from an employer retirement fund, and not to any other retrenchment bonuses or gratuities (other payments) your employer pays you. Depending on your circumstances, retrenchment bonuses and gratuities qualify for the R30 000 tax exemption in terms of section 10(1)(x) of the Income Tax Act, with the balance being taxed at your average rate of tax.
Note:The tax information used in this article is for the tax year ending February 2011.