Section 10C: Income tax strategies in retirement structuring

By Ruan Breed *

One of the more misunderstood corners of SA’s retirement legislation is what happens when an investor contributes more to a retirement fund than they are allowed to deduct in a given tax year. Many assume that anything above the limit is simply money not put to good use. Well, the opposite is true.

Section 10C of the Income Tax Act ensures that these so-called excess, or disallowed contributions are retained and eventually deliver real tax relief, often in the form of tax-free annuity income in retirement.

Where the problem starts

Section 11F caps the annual deduction for retirement fund contributions at the lesser of R430 000, 27.5% of the higher of remuneration or taxable income, or taxable income itself. Any contribution above that ceiling is not deductible in that tax year. But rather than being lost, the excess is carried in the investor’s name and applied later, in a strict order set by the legislation.

That order matters as well. Excess contributions are first carried forward and deducted under section 11F in future years where the limits allow. If a retirement or withdrawal lump sum is taken, any remaining balance must then be applied against the taxable portion of that lump sum under the Second Schedule, before the retirement tax table is applied. Only after that, once the investor is drawing a compulsory annuity, can whatever remains be used to exempt annuity income under Section 10C. Importantly, balances are aggregated across all of the investor’s retirement funds, and a lump sum always takes priority.

How does it work?

Section 10C exempts qualifying annuity income, which is income from a compulsory annuity, (including a living annuity) to the extent that disallowed contributions remain. In practice this can mean a portion, or even all, of a retirement income stream is received tax-free until the balance is exhausted.

Two practical points are worth flagging up front. First, the exemption gives no upfront relief: the annuity administrator must still deduct PAYE in full, and the benefit is only applied by SARS on assessment, usually as a refund. There are no SARS tax directives for section 10C. Secondly, the exemption belongs only to the member who made the contributions. It cannot be passed to a beneficiary on death, and it does not apply to a pension paid by the GEPF.

A useful habit is to watch the disallowed-contribution balance reflected on the investor’s ITA34, and to make sure the annual contribution certificate is included in the tax return to ensure that the credit is correctly recorded.

A simple example

Take investor, John, who retires with R4 000 000 of previously disallowed contributions. He takes a R2 500 000 lump sum and invests the balance in a living annuity.

The lump sum is dealt with first. The R2 500 000 is reduced by R2 500 000 of disallowed contributions, leaving a taxable lump sum of R0 where no tax is payable. That leaves R1 500 000 of disallowed contributions available to offset against future annuity income, from the resultant annuity.

In year one, John draws R900 000 of annuity income. The full R900 000 is exempted, leaving R600 000 of the credit intact. In year two he draws R1 000 000. Only R600 000 is exempted, the remaining R400 000 is taxable, and the credit is now used up. From there, his annuity income is taxed normally according to relevant tax tables. An important note to remember is that the gross income from the resultant annuity is offset against the credit, not the net income. That means the credit will be offset quicker.

Why and for who?

For higher-net-worth investors, entrepreneurs who have sold a business, or anyone catching up on years of under-provision, section 10C turns surplus contributions into a stream of tax-efficient income. This is also an excellent strategy especially for clients/families who have an asset base /portfolio heavily skewed towards discretionary funds and less so retirement structures. This creates valuable room for estate planning.

There is also an estate planning dimension worth understanding clearly. The section 10C exemption itself dies with the member. A beneficiary who inherits the annuity does not inherit the benefit of receiving that income tax-free. However, the estate duty position is separate and more favourable. If the beneficiary elects to continue with the living annuity, any remaining disallowed-contribution balance still falls outside the original investor’s dutiable estate. It is only when the benefit is taken as a cash lump sum that this balance is dragged back into the deceased’s estate under section 3(3)(e) of the Estate Duty Act, with no spousal section 4q relief available. In other words, annuitising preserves the estate duty advantage even though the income tax exemption is lost. A distinction that often drives the right advice on death.

Used deliberately, it is a quietly powerful tool. The key is structuring contributions and the eventual drawdown with the order of application firmly in mind.

* Ruan Breed is a wealth manager at Brenthurst Wealth Stellenbosch and also serves clients in George, Western Cape, and Limpopo Province.