Retirement funds remain one of the most tax-efficient investment vehicles available to South Africans. Whether contributing towards a retirement annuity, pension fund or provident fund, taxpayers can enjoy upfront tax deductions, tax-free growth within the fund, and favourable tax treatment upon withdrawal. However, it is important to understand the financial implications and opportunities of making contributions above the annual tax-deductible threshold, commonly referred to as retirement fund over-contributions.
While often overlooked, these over-contributions can play a valuable role in one’s long-term investment strategy, particularly for investors seeking to maximise tax efficiency over time. Here we unpack the concept of over-contributions, explore how they are treated by SARS, and consider their strategic application in one’s retirement plan.
Understanding the annual deduction limits
In terms of current legislation, taxpayers are permitted to deduct contributions to retirement funds of up to 27.5% of the greater of their taxable income or remuneration, capped at an annual limit of R350 000. Keep in mind that this threshold applies collectively to all contributions made to a pension fund, provident fund or retirement annuity in a given tax year. What’s important to note is that the R350 000 cap is an annual deduction limit rather than a contribution limit – meaning that investors can contribute more than the deductible threshold, but they won’t be able to claim a tax deduction for the amount exceeding that limit in that tax year.
By way of example, an individual with a taxable income of R2 million per year may contribute R600 000 to a retirement annuity, but will only be permitted to deduct up to R350 000 from taxable income in that tax year, while the remaining R250 000 will constitute an over-contribution.
What happens to over-contributions?
Although these excess contributions do not result in an immediate tax deduction, it’s important to note that they are not lost or forfeited. SARS tracks these over-contributions over time and allows the investor to deduct them in future years, either when additional contribution room becomes available or when benefits are eventually withdrawn from the fund. In other words, over-contributions are carried forward and can be used to offset future tax liabilities. From a practical perspective, over-contributions are recorded on your tax return and reflected by SARS in your retirement fund contribution balance, which is typically visible in your eFiling profile after annual assessment.
Tax treatment upon retirement
One of the most significant advantages of over-contributions is the role they play in reducing the tax payable on retirement benefits. When a member retires and elects to take a portion of the retirement fund as a lump sum, the benefit will be taxed according to the retirement tax table. However, any portion of the lump sum that constitutes previously disallowed contributions (i.e. over-contributions) will be free from tax. This can result in significant tax savings, especially for those investors with large accumulated over-contributions.
Similarly, when it comes to drawing down from the remaining two-thirds of the fund, over-contributions can be used to reduce the taxable portion of the annuity income, thereby providing a tax-free return of capital during retirement. Lastly, where an investor dies leaving over-contributions in a retirement fund, these excess contributions can be used to reduce the tax liability on lump sum death benefits paid to beneficiaries.
Why investors make over-contributions
There are a number of strategic reasons why investors may choose to over-contribute to their retirement funds. Some of these include the following:
- Maximising long-term tax efficiency: Remember, while the deduction on over-contributions is delayed, they still enjoy tax-free growth within the fund and can reduce tax payable at retirement.
- Capital protection: Funds in a retirement fund structure are generally protected from creditors, meaning that over-contributions can be a useful tool for asset protection.
- Forced discipline: Because retirement fund assets are typically inaccessible until age 55, over-contributions can be a way to preserve capital for long-term use.
- Estate planning: In the event of the member’s death, any remaining over-contributions can help reduce the tax on lump sum death benefits, effectively increasing the inheritance available to loved ones.
Important considerations
While there are distinct advantages to over-contributing, it’s important that investors keep the following in mind:
- Liquidity constraints: Because retirement funds are illiquid in nature, over-contributing means that you will be locking away your funds for a long period of time. As such, the benefits of over-contributing should be weighed against other financial needs, such as emergency savings or discretionary investment.
- No immediate tax relief: The tax relief brought about by over-contributing is delayed and, as such, should be used as part of a long-term strategy and not a short-term tax-saving tactic.
- Record-keeping: It’s important that investors keep accurate records of the retirement fund contribution and ensure that they are correctly reflected on their SARS tax profile, as errors in reporting may delay or negate future tax relief.
Avoiding penalties and misreporting
Following on from the above, it’s important that investors accurately declare their over-contributions to SARS and do not mistakenly claim them as tax-deductible in the year they are made, keeping in mind that incorrect reporting can result in the disallowance of deductions, interest charges or even penalties. When filing tax returns, investors should ensure that their retirement fund administrators provide a consolidated IRP5 or IT39f form reflecting the total contributions for the tax year, split between deductible and non-deductible.
The role of discretionary retirement planning
While over-contributing to a retirement fund can be an effective strategy, especially for high-net-worth individuals or those with fluctuating income levels, it’s important to balance the benefits against alternative vehicles such as tax-free investments, endowments and/or discretionary unit trusts, which may offer greater liquidity and investment flexibility.
While the term ‘over-contribution’ may suggest an inefficiency, it can be a powerful financial planning tool when used intentionally as part of a holistic strategy. Provided that investors fully understand the implications and maintain accurate record-keeping, making excess contributions can enhance long-term tax efficiency, protect capital and provide meaningful tax relief at retirement or death. If you’re considering using over-contributions in your investment strategy, our advice is to consult with an independent financial planner who can assess your broader financial goals, time horizon and cash flow needs.
Have a fantastic day!
Sue
