This is the seventh in a 10-part series on how to structure your life-time finances. The series has been prepared by Personal Finance in conjunction with Old Mutual.
The few years before retirement are scale-down time, tax planning time, estate planning time and lifestyle planning time.
Retirement is not simply a matter of stopping work on a particular day and spending the rest of your life on a beach or playing golf. You need to make decisions on a variety of issues in the years leading up to retirement.
These issues include where you will live and what you intend to do with your retirement years, particularly as they can be equivalent to about one-third of your life.
The most important issue to tackle before you retire is tax planning. You are about to be hit with probably the biggest dollop of lump-sum money you will receive in your life (that is unless you had a rich unknown aunt who lived in outer Mongolia, and left you R20 million when you were 21). With it you are also probably going to be hit with your biggest tax bill.
The money will come from your retirement savings. The amount will vary depending on whether you were in a defined benefit retirement scheme, a defined contribution scheme, a defined contribution provident scheme, a retirement annuity scheme or a mix of these.
Next week we will look at the investment options for this money, but you need to start planning at least three years before you retire to minimise the tax consequences of this flow of money.
Taxation is one of the most important elements of retirement planning. Get it wrong and it could reduce your standard of living in retirement.
Because of the complexity of retirement taxation it is essential that you get proper advice from a recognised tax consultant before and at retirement to avoid making a mistake that could cost you dearly in later years.
One of the most important elements in making decisions on tax immediately before retirement is to know the difference between the marginal rate of tax and the average rate. South Africa has a progressive personal income tax system - the more you earn the greater the percentage you pay in tax.
The average rate of taxation is the average amount of tax you will pay on your income. For example, with an income of R100 000 you would be on the marginal rate of 45 percent but your average rate of taxation would 30,8 percent. In other words after averaging out all the different amounts you pay in the various marginal rate tax brackets you would pay R30 835 in tax.
Your lump sum benefits will be taxed at your (lower) average rate of tax. The challenge that faces you is to reduce your average income. The average rate is based on the highest of:
* Your average tax rate in the year in which you retire; or
* The average rate for the preceding year.
As a result the timing of your retirement is critical. The important issues you need to consider are:
* Date: Retire as early in the tax year as possible because under current taxation regulations your lump sum payments are taxed at your highest average rate of tax in the current or previous tax year. Retiring early in the current tax year will reduce your taxable income substantially because you will be receiving a pension and not a salary plus perks. Then you can concentrate on reducing your non-pensionable income in the tax year before retirement;
* Regular income accrual: Reduce your income to a minimum in the year before retirement. Do not for example work overtime or do work that results in extra commissions or earn unnecessary interest on investments or cash for accumulated leave; and
* Lump sums: Do not take share options or proceeds from a retirement annuity. Keep these until at least another year after retirement at which point your income level will be lower as will your tax rate. Again your highest average rate of the current and the previous year are used to tax any retirement annuity lump sum.
There are complex formulas for exactly how much tax you will pay depending on the type of retirement fund of which you are a member. There are exemptions starting with a basic exemption of R120 000; or R4 500 multiplied by the number of years as a member of the fund.
Husbands and wives are each entitled to the exemptions, even when married in community of property. This is particularly useful in retirement planning even if a spouse is unemployed, as you can make retirement annuity contributions on behalf of your spouse either over a number of years or as a lump sum which can double the exemption.
You cannot stagger lump sum benefits to claim the tax exemption more than once. For example if you received the full tax exemption allowed on a lump sum benefit when you retired you cannot again claim that benefit on the maturity of a retirement annuity, say five years later.
Civil servants are different from the ordinary mortals in that they until now have not paid tax on lump sums. This however changes from next year but portion of a lump sum that accrued before March 1998 will remain tax free.
