It is widely known that a retirement annuity (RA) offers income tax benefits on contributions up to certain limits, but that access to the proceeds of the RA is restricted until retirement. The estate planning benefits of an RA are perhaps not as well understood.
I recently engaged with Ninety One, one of South Africa’s most prominent asset managers, through one of their Masterclass Series events. In it, Ninety One provided some in-depth knowledge into this field and I would like to share some of the key insights.
Certain RA benefits are sometimes overlooked.
- For instance, it offers a protective layer against creditors in the event of financial distress. This is because strictly speaking, the proceeds don’t belong to you, but rather to the trustees of the RA.
- Furthermore, the growth potential of the funds in the RA is maximised through the exemption of dividend-withholding tax, income tax, and capital gains tax while in the fund.
- The proceeds from an RA is also exempt from estate duty since it does not form part of the investor’s estate. I would like to discuss this last point in greater detail, specifically how a disallowed contribution (DC) may benefit the investor at and during retirement, and the beneficiaries of the estate at the time of death.
A DC is either monthly or lump-sum RA contributions made, over and above the tax-deductible limit during a tax year. A DC does not attract tax benefits during the tax year during which the contribution is made. Rather, an investor’s DC may be used to reduce or even completely neutralise the amount of tax paid on the income from an RA, depending on the amount of the DC. If the investor decides not to take a lump sum at retirement, they can still benefit from a tax deduction by not being taxed on the income until the DC amount has been fully utilised.
If the investor or their beneficiaries decide to emigrate, they also benefit from a tax-free amount equal to the value of the DC before the usual withdrawal tax table is applied. Any DC remaining at death will be free of estate duty if the beneficiaries choose to receive the inheritance in the form of monthly income rather than a lump sum.
To illustrate the financial benefit DCs may hold in a more easily digestible manner, I’ll use an example that was presented by Ninety One during the Masterclass Series events.
- John is 70 years old and a recently retired entrepreneur.
- He sold his business for R40 million.
- He does not have a spouse but has two children.
- He commits R40 million to an RA.
- He retires from the RA at the end of the tax year that the contribution was made to.
What are the benefits that he has received up till now?
- He has pegged the size of his estate.
- He receives tax-free growth inside the RA wrapper.
- He will have tax-free income until the DC is exhausted.
- His estate duty is reduced by the total amount of income drawn. Keep in mind that the R40 million DC is still deemed an asset in his estate.
John now passes away at age 80 and he nominates his trust as a beneficiary.
- The value of the RA has grown to R60 million.
- The balance of the DC is R20 million. This implies he received tax-free income for the 10 years since retirement.
Let’s consider the implications of the two most likely outcomes:
The trust elects to take the proceeds as a lump sum:
- Rather than the full R40 million, only the remaining unutilised R20 million is included in the estate.
- The R20 million is not taxed according to the retirement tax tables.
- Future growth will be taxed at 45% on income and 36% on capital gains since the proceeds are now owned by the trust and not in a retirement product.
The trust elects to receive the proceeds as monthly income from the living annuity:
- The full R60 million is excluded from the estate. This represents an immediate saving of R5 million (R20 million x 25%) in estate duty.
- The full value in the investment may be transferred to an annuity tax-free. The trust can now apply to have the income taxed in the hands of the beneficiaries of the trust, which will likely be at a lower rate than in the trust itself.
Traditionally, RAs have had a lot of bad press; and legitimately so. Unreasonably high fees, punitive penalties for transferring, stopping or reducing premiums, all have resulted in an investment that performed poorly. In extreme cases, the value of an RA may even be less than the sum of the contributions made.
Thankfully, the situation has improved dramatically with the advent of linked investment service providers (LISPs). You may now reduce, increase, transfer, make underlying fund changes and even stop contributions without costs or penalties. Furthermore, advisers’ interests are now mostly aligned with their clients, since they typically earn a percentage of the assets under their advisement.
The better the assets perform, the more they will earn. I do believe that this arrangement could be further improved upon; perhaps a part of the advisor’s income should be linked to the relative performance over the peer group, but that is a topic for another discussion.
In closing, I’d like to make an important note on the performance of retirement products, or any investment for that matter. The product itself is not the driver of performance for the investment. Neither is the LISP, or platform on which the product is hosted. The product is but a shell with certain benefits and restrictions linked to it. The underlying fund choice is what makes all the difference.
To use an analogy, you may think of your investment like a car. Two variants of the same model will appear almost identical from the outside, but the one with the more powerful engine will outperform the other in all circumstances. In this analogy, the underlying funds of your investment are the engine. It is by far the biggest contributor to the end value of your investment. Ensuring that it is chosen with care with the support of a professional advisor is pivotal.
Please feel free to contact us to assess which engine is most appropriate for you.