The need to make some provision for retirement should be one of your first considerations if you receive a lump sum through inheritance or retrenchment.
A product often mentioned in Personal Finance pages is retirement annuities. You may think this suitable, but is it?
Dave Avnit, general manager individual life at Fedlife, explains that a retirement annuity (RA) is a product offered by the insurance industry which helps investors accumulate funds for retirement in a highly tax-efficient manner.
The contributions you make to an RA are deductible from your income, reducing the amount of personal tax you pay. When you retire there are also tax planning opportunities.
An RA has the same one-third/two-thirds structure on retirement that a pension fund does.
According to legislation, when you retire, one-third of the value of the RA may be taken in cash, and the other two-thirds must be invested in a vehicle paying you a monthly income.
A large proportion of your one-third cash payment can be tax free. The tax-free portion is calculated as the greater of R120 000 or R4 500 multiplied by the number of years that you have contributed to the pension or RA.
The tax-free allowance is reduced proportionately if you received a previous tax-free lump sum.
The tax rate on the one-third portion is calculated on your average rate of tax, excluding the lump sum.
So if you earned R100 000 in the same year as you received a lump sum of R50 000, and paid an average rate of 34 percent tax on the R100 000, the same average tax rate would be applied to the lump sum.. You are not bumped up into a higher tax bracket by the receipt of the R50 000.
There are also opportunities to make sensible tax arrangements on the other two-thirds of the lump sum, particularly if you don't need a monthly income immediately. You can receive a lower monthly income at first, increasing in future years. In policies such as Fedlife's Variable Investment Annuity you also have a choice of investment vehicles.
However, an RA is not always the best investment for a lump sum received through inheritance because that sum is not taxable anyway, Avnit says.
The main advantages of an RA are that it has tax benefits and that it locks your money away until a minimum age of 55 and maximum of 69, so it is a disciplined retirement vehicle.
Avnit says if you want to provide for your retirement with your inheritance, you could consider routing that sum into an investment that pays an on-going income, which in turn should be invested into an RA.
The maximum tax deduction for a lump sum investment into an RA is 15 percent in one year, but you could get 15 percent a year on a larger sum by contributing to an RA over several years.
Also, at the end of the period, the tax-free portion on the first one-third, as already stated, is the greater of R120 000 or R4 500 multiplied by the number of years during which you contributed to the RA or pension. If you made a lump sum investment, it only counts as one year of contribution.
What sort of investments would be suitable to feed into an RA? Avnit says gilts or participation bonds, the income from which is taxable, would be suitable to invest in an RA because of its kinder tax structure.