How to avoid paying income tax in retirement (and pass on your wealth to your kids, tax-free)

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Ok, so if we had more room in the title of this article, it would also say “…by saving extra hard and planning very, very well”. We’re not pretending that not paying income tax in retirement and being able to leave money to your children without them being taxed is easy. But it is possible.

How, you ask?

By leveraging section 10C of the Income Tax Act.

Most people focus on maxing out their annual tax deductions, but miss a powerful opportunity presented by understanding Section 10C and the combination of a retirement savings vehicle like a retirement annuity and, later on, a living annuity.

The way we see it, there are two major benefits that Section 10C offers: the potential for tax-free income in retirement (including a bigger tax-free lump sum when you retire), and the ability to leave extra retirement savings to beneficiaries, tax-free. Let’s get into each of these in turn. But first, let’s just understand Section 10C a little better.

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Disallowed contributions: Section 10C in a nutshell

If you want to get tax back on your retirement savings, you are currently limited to 27.5% of taxable income, capped at R350,000 per year. Your tax deduction will happen immediately on contributions up to this limit - they will reflect on your payslip through PAYE if you are contributing to a company pension or provident scheme, or come back to you at the end of tax year if you are contributing to a retirement annuity.

But what happens when you contribute more?

These extra contributions are called ‘disallowed contributions’. And although you don’t derive any benefit from them immediately, they don’t disappear, either. Instead, they build up in a ‘pool’, and it’s this pool that becomes your secret retirement tax weapon.

Extra retirement savings can mean no income tax in retirement

Retirement lump sums

When you want to retire, the standard tax-free lump sum that you can take from your retirement savings at that time is R550,000 (assuming no previous withdrawals). But now, your pool of disallowed contributions can be added to this amount. And to be clear, we’re only talking about the actual contributions, not the growth those contributions might have accrued while invested.

So, if you had R1m disallowed contributions, that would mean your standard R550,000 tax-free lump sum and your R1 million of disallowed contributions are now available to you as a tax-free lump sum, should you wish to withdraw it all at retirement (so R1,550,000 in total).

In retirement: Tax-free annuity income

When you retire, you will need to transfer your retirement savings to a living annuity or a life annuity. And your pool of disallowed savings goes too.

Your are able to offset your annuity income against the pool, paying zero tax on annuity income until the pool is depleted (once again, we are talking only about the total number of disallowed contributions in the pool, not the growth on those contributions). This means that depending on how much extra money you have saved, you could be entitled to years of tax-free retirement income. Neat, isn’t it?

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The estate planning bonus: Leaving tax-free money to your beneficiaries

This is another key benefit of disallowed contributions: they can potentially be transferred to beneficiaries outside of your estate. Let’s look at an example to illustrate how this can work.

Let’s say you have R700,000 of disallowed contributions in a retirement annuity. That’s two years’ worth of tax deductible savings (because of the R350,000 per year limit). You then transfer your savings into a living annuity.

In the first instance, you work through the R700,000 pool of disallowed contributions in two years by drawing tax-free income from your living annuity. In this case, your disallowed contributions will not be considered part of your estate at all, and your beneficiaries will not pay estate duty on those funds whether they take them as a lump sum or if they keep them in the living annuity.

In the second instance, you pass away before working through the R700,000 disallowed contributions. If your beneficiaries take those funds as a lump sum, those funds will be considered part of your estate and will be taxed accordingly. If your beneficiaries choose to keep those funds in a living annuity, the disallowed contributions will fall away and not be considered part of your estate.

Now you see the power of disallowed contributions as a wealth transfer device, especially if your beneficiaries (and their beneficiaries in turn) are disciplined about keeping the funds in a living annuity. Over time, this can become a truly life-changing amount of money.

The post-retirement Retirement Annuity: A smart savings and estate planning strategy

So even if you are retired or about to retire, a retirement savings vehicle like a retirement annuity can still be a great options for you going forward. You could consider putting windfall money (from the sale of a house, say) or other discretionary savings into a retirement annuity, which can have some great benefits:

• You get tax-free growth, and the tax benefits of those contributions will count towards the retirement income you are drawing or intend to draw;
• You will have a great option for transferring wealth to your beneficiaries - especially if they keep those funds in a living annuity.

If you'd like to discuss any of this, our highly-experienced investment consultants are on-hand to give you the facts about your retirement savings. No advice, just all your options, laid out and crystal clear. Get in touch today.

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