Question

I own several rental properties, so my estate is quite large.  I recently sold a property for R10 million and would like to invest the money to supplement my pension in a tax-efficient way. I would like to reduce the estate duty and executor’s fees that my family may face one day.

I have heard that I can invest the money in a disallowed retirement annuity and use something called section 10C to receive a tax-free income. How does this work, and what should I be careful of?

Answer

This can be a very effective strategy, but it needs to be understood properly.  Let us start with the basics.

You get a tax break on your retirement contributions of 27.5% of your taxable income up to a maximum of R430,000 a year.  If you contribute more than this, the extra amount cannot be claimed as a tax deduction in that year.  This excess is carried forward to subsequent years. These carried-forward amounts are often called disallowed contributions.

Let us assume that you contribute the full R10 million to a retirement annuity.  You will not receive a R10 million tax deduction. Depending on your income and other retirement-fund contributions, you may be able to deduct up to R430,000 in the first year. The rest of the contribution is carried forward as a disallowed contribution.

That description sounds rather negative, but the money has not been rejected or lost. It simply means that you have contributed money for which you have not yet received a tax deduction.

These contributions can continue to be carried forward and may be used in future years.

When you retire from the retirement annuity, the money can be used to provide an income through a living annuity.  In your instance where you want to draw an income immediately, you would retire from the RA immediately.  (this is often referred to as a “one day RA”)

Income from a living annuity is normally taxable.  However, section 10C recognises that you may have contributed some of the money without receiving a tax deduction. It would be unfair for SARS to tax you again when that same money is paid back to you.

Section 10C therefore allows part of your annuity income to be received tax-free, using the balance of your contributions that have never previously received a tax benefit.

The tax-free treatment continues only while you still have unused disallowed contributions available. Once those have been used up, the income will again become taxable in the normal way.

So, if you invested your R10m into a one-day RA and then convert it to a living annuity, the income form this annuity would be tax free until the disallowed contribution is used up.

Tax free investment growth

The investment inside the living annuity does not attract tax on interest, dividends or capital gains in the same way that a normal investment would.  This allows the full investment to continue working for you.  Over a long period, this tax-free growth can make a meaningful difference, particularly where a large amount is invested.

Estate duty savings

A living annuity that is funded by disallowed contributions will not trigger estate duty if the beneficiaries elect to receive the proceeds as an annuity.  If they take the proceeds as a lump sum, it will form part of your estate.  By using this structure, you could around R2m in estate duty on your R10m investment.

Executor fees

If you nominate a beneficiary, no executor fees are payable.  This could save you around R400 000 in executor’s fee on this R10 million investment.

You would typically nominate your spouse as the beneficiary of the living annuity and have your children or grandchildren as secondary beneficiaries to receive the benefit should your spouse pass away.  The income would be taxable in their hands even if it came from a disallowed contribution.  However, there would be the estate duty saving which would make this an attractive proposition.

Caveats

The biggest practical concern is access to your capital.

Before investing the proceeds, you should therefore set aside enough accessible money for: the capital-gains tax arising from the property sale and ensuring that you have a well-funded emergency fund.

What about the rental properties?

You could consider selling some of the rental properties and following a similar strategy, particularly if the properties are creating a large taxable rental income.  Rental income is taxed at your marginal tax rate. By comparison, this structure provides an extremely tax efficient income structure.

Section 10C can be one of the most effective tools available to someone who has substantial capital, sufficient accessible savings and a long-term need for retirement income.

It offers:

• tax-free growth inside the investment;
• tax-free annuity income till the disallowed contributions are exhausted;
• estate duty savings
• savings in executor’s fees

However, before investing the property proceeds, you should speak to a properly qualified financial adviser who can perform a proper cash-flow, tax and estate analysis for you.