FINANCIAL WELLNESS COACH: Turning property proceeds into a tax-efficient retirement income

You can never escape the taxman entirely, but you can use clever investment strategies to avoid your estate owing big chunks of money.

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 (RA) and use section 10C to receive a tax-free income. How does this work and what should I be careful of?

This can be a very effective strategy, but it needs to be understood properly.

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 an RA. 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. This 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 RA, 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. 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 R10-million in a one-day RA and then converted it to a living annuity, the income from this annuity would be tax-free until the disallowed contribution is used up.

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.

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 save about R2-million in estate duty on your R10-million investment.

If you decide to nominate a beneficiary, no executor’s fees are then payable.