There’s been increased discussion about Section 10C and disallowed contributions, but what do they mean, and how can they help you? These concepts are vital for retirement planning, tax savings, and estate planning, even if they seem complex. Let’s simplify them.
What is section 10C?
Section 10C of the Income Tax Act allows contributions to your retirement fund beyond the annual deductible limit. You can claim deductions for contributions up to 27.5% of your taxable income, up to R350,000 per year.
Can you contribute more? Yes, and if you do, those extra contributions—known as disallowed contributions—don't provide an immediate tax break, but they can later help reduce your tax bill in retirement.
How can disallowed contributions benefit you?
Before retirement - tax-free growth
Retirement assets offer additional tax benefits beyond those previously mentioned. All growth within the retirement fund, including interest, dividends, and capital gains, accumulates tax-free, allowing for enhanced long-term wealth accumulation and tax-efficient retirement planning.
It reduces the taxable portion of your lump sum withdrawal
When you retire, you can take up to one-third of your retirement savings as a lump sum, with the first R550,000 tax-free. However, disallowed contributions reduce the taxable portion, lowering your overall tax liability.
Here’s an example:
If you take a R1,500,000 lump sum at retirement and have R500,000 in disallowed contributions:
Lump sum withdrawn: R1,500,000
Less: disallowed contributions: (R 500,000)
Taxable amount: R1,000,000
This results in a lower tax bill, helping you keep more of your retirement savings.
It reduces your taxable income during retirement
If you don’t use all your disallowed contributions to offset your lump sum tax, the remaining amount can reduce the taxable portion of your retirement income. This means that part of the income you receive from your annuity will be tax-free, helping you stretch your retirement savings further.
Here’s another example:
Mrs. Smarty retires with R1,000,000 in disallowed contributions and invests in a living annuity, drawing R480,000 per year (R40,000 per month). Her disallowed contributions offset her annuity income, keeping it tax-free until fully used. Once depleted, her annuity income will be fully taxable, allowing her to delay taxes and extend her retirement savings.
When does this strategy make sense?
While disallowed contributions offer great benefits, they aren’t for everyone. Once your funds are in a retirement investment, access to them becomes limited. Here’s why:
Restricted withdrawals
Before retirement, you can only withdraw from the "savings component" once yearly, and the withdrawal is taxed at your marginal tax rate.
Retirement limits
At retirement, you can only take out the portion in the savings component and, in some cases, the vested portion as a lump sum, which is taxed according to the retirement/ withdrawal tax tables (we explained this in our previous article on the Two-Pot Retirement System).
Income restrictions
The remainder of your retirement savings must be transferred into a compulsory annuity (life or living annuity), which provides you with an income for life. However, you can only withdraw between 2.5% and 17.5% per year of the living annuity and adjust this rate once per year.
Disallowed contributions provide tax benefits but come with restrictions. Without accessible investments (non-retirement investments), you may lock in your capital, limiting financial flexibility at retirement. This is crucial for accessing larger sums for unexpected expenses like medical emergencies or significant financial commitments such as home repairs or vehicle purchases.
Who, then, can benefit from this strategy?
If you have a healthy balance between retirement and non-retirement investments, disallowed contributions can be an excellent tool for:
Tax planning
Disallowed contributions can help reduce your ongoing tax liability in retirement. If you have a significant amount accumulated, it can lower the taxable portion of your annuity income, potentially allowing you to receive tax-free income for several years. This can be particularly beneficial for retirees looking to maximize their cash flow while minimizing tax obligations.
Estate planning
- Retirement savings are not subject to estate duty. This makes them an excellent tool for reducing your taxable estate.
- However, disallowed contributions that have not been used will form part of your estate, depending on how your beneficiaries choose to receive their portion of the retirement investment.
- If your beneficiaries keep the funds in a living annuity, the disallowed contributions will disappear and not form part of your estate.
- If your beneficiaries choose to receive a lump sum, these may be subject to estate duty.
- For this strategy to work efficiently, you must use up your disallowed contributions during your lifetime.
Foreign beneficiaries
This strategy can become complicated if your beneficiaries live overseas. Foreign beneficiaries typically prefer to receive their inheritance as a lump sum instead of leaving it in a South African living annuity. If they choose this option, unused disallowed contributions will be added to your estate and may be subject to estate duty.
When planning for retirement, you should prioritise your financial well-being. You have worked hard for your money—it should benefit you first before benefiting your heirs.
Final thoughts…
Disallowed contributions offer significant tax and estate planning advantages, but they are not for everyone. While they can reduce one's tax burden in retirement, they also limit one's access to funds.
This strategy is ideal for those with sufficient non-retirement savings who want to maximise tax efficiency and preserve wealth for retirement. However, if beneficiaries are offshore or prefer a lump sum, unused disallowed contributions may become part of your estate, potentially incurring estate duty.
Foundation Family Wealth understands that effective retirement planning is about balancing tax benefits with the financial flexibility you need. That’s why we work closely with you to tailor a plan that aligns with your lifestyle goals and long-term security. Our goal is to help you create a retirement strategy that meets your unique needs and provides peace of mind for the future.
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