Is it beneficial to invest an additional lump sum to your retirement annuity (RA) if you already contribute the max 27.5% per year?
Dear reader,
There are significant benefits to overcontributing to a retirement fund, either before retirement or during retirement. This can include a retirement annuity or a pension/provident fund through your employer, or a combination of both.
The legal framework and contribution limits
The law allows individuals to contribute up to 27.5% of their annual taxable income or remuneration to these retirement products, with a cap of R350 000 per year. These contributions are eligible for tax deductions on an annual basis.
The tax benefit of overcontributions
Should you exceed the standard contribution limits, a secondary tax benefit comes into play, referred to as Section 10C. This provision allows for “disallowed contributions,” which can be utilised at a later stage, specifically during retirement. Essentially, these are contributions made beyond the allowable limits that provide a future tax benefit when you retire and convert your retirement products into a living or life annuity.
How Section 10C works
Any contributions exceeding the annual 27.5% or R350 000 limit accumulate into what is known as a “disallowed contributions pool”. Upon retirement, your retirement products are converted into a life or living annuity, from which you will start drawing an income.
In the case of a living annuity, you will be required to select an income percentage ranging from 2.5% to 17.5% of the fund’s value. This income is subject to tax according to the Pay-As-You-Earn (PAYE) tax scales.
At this point, the disallowed contributions “pool” becomes available for use. You may offset this pool against the income earned from your annuity. It is important to note that this offset applies to the gross income, meaning the pool will likely be depleted more quickly. Therefore, the larger you can build your disallowed contributions pool, and the lower your drawdown percentage from the annuity, the longer you can offset the associated income tax.
Illustrative example
Consider the following scenario:
- Disallowed contributions amount to R20 million.
- You select an annual gross income (before tax) of R1 million from your living or guaranteed annuity.
In this case, the disallowed contributions would offset the income tax on your annuity income for a period of 20 years.
Complementary tax-efficient strategies
In addition to maximising Section 10C, combining this strategy with a tax-free investment account can further enhance tax efficiency. Other vehicles, such as endowment or sinking funds, can be considered for more liquid requirements over time. By prioritising equity exposure within these vehicles, you can ensure a reduced effective tax rate, which can be capped at 12% (as income tax is capped at 30% and capital gains tax is capped at 12%).
The combination of these strategies ensures a flexible and tax-efficient retirement plan.
Protecting your legacy
Optimising Section 10C also provides an excellent strategy for ensuring that your loved ones are taken care of. Retirement products are typically excluded from your estate and are directly transferred to your beneficiaries. However, it’s important to note that the disallowed contributions will be treated as a deemed asset in the deceased’s estate.