By Dawid Oosthuizen, Associate, AJM
Introduction
The taxation of lump-sum amounts often causes confusion, primarily because the events that trigger such taxation do not occur annually and may arise only once or twice during a taxpayer’s lifetime.
Most employees are aware that they may become entitled to a lump-sum payment on retirement or upon leaving employment. Because these amounts are typically taxed through directives issued by South African Revenue Service and withheld at source by employers or retirement funds, they are often accepted at face value. In practice, however, the underlying tax mechanics deserve closer scrutiny, particularly given the cumulative nature of lump-sum taxation.
This article provides a practical overview of the different categories of lump sums, how they are taxed, and the planning considerations that can materially affect the final outcome.
Type of Lump-Sum Payments
Lump sums arising from retirement or the termination of employment (excluding public sector funds) generally fall into one of three categories:
Severance benefits
Severance benefits are lump-sum amounts received because of the termination of employment or a material change in the terms of employment. These amounts are typically paid by the employer or an associated institution.
A payment qualifies as a severance benefit for purposes of the Income Tax Act where the employee:
- has attained the age of 55;
- is required to leave employment due to incapacity or ill-health; or
- is retrenched.
In addition, the employee must not have held, at any time, more than a 5% interest in the employer where the employer is a company or close corporation. Amounts that do not meet the statutory definition of a severance benefit are taxed at the employee’s normal marginal income tax rates.
Retirement Fund Lump-Sum Benefits
A retirement fund lump-sum benefit arises when an amount accrues to a taxpayer from a retirement fund upon retirement or death. This includes amounts from pension funds, provident funds, retirement annuity funds, and preservation funds.
Retirement Lump-Sum Withdrawal Benefits
A retirement lump-sum withdrawal benefit arises where amounts are withdrawn from a retirement fund prior to retirement, most commonly on resignation or termination of employment. Amounts that accrue to a spouse in terms of a divorce order also fall within this category.
How Lump Sums Are Taxed
Severance benefits retirement fund lump-sum benefits, and retirement lump-sum withdrawal benefits are all expressly included in a taxpayer’s gross income. Despite this inclusion, they are taxed at preferential rates that differ from those applicable to ordinary taxable income.
The applicable tax tables are not contained in the Income Tax Act itself but are published separately through annual tax legislation. Lump sums are taxed in accordance with progressive tables that mirror the structure of normal income tax rates, but with an important distinction: lump sums are ring-fenced from a taxpayer’s other income, deductions, allowances, and rebates. The tax calculation is performed in terms of the Second Schedule to the Income Tax Act. As a result, a taxpayer’s salary or business income in the year of receipt has no bearing on the tax payable on the lump sum. Amounts that are transferred directly to approved retirement vehicles, such as preservation funds or retirement annuities, are excluded from the lump sum before the applicable tax rate is determined.
Tax-Free Thresholds and Policy Intent
Severance benefits and retirement fund lump-sum benefits are taxed according to a table that provides for a tax-free threshold of R550,000. By contrast, retirement lump-sum withdrawal benefits are taxed from the first R27,500 received.
This disparity reflects a clear policy objective: to discourage early access to retirement savings and to preserve those savings for retirement.
The Cumulative Nature of Lump-Sum Taxation
One of the most frequently misunderstood aspects of lump-sum taxation is that it applies on a cumulative, lifetime basis. All prior lump sums received by a taxpayer are aggregated when determining the applicable marginal tax rate.
By way of example, if a taxpayer received a severance benefit of R100,000 in 2015 and later retires with a lump sum of R500,000, the tax ] rate is determined as if R600,000 had been received. Only the R500,000 is taxed at retirement, but it is taxed at the higher marginal rate applicable to the cumulative amount.
To prevent double taxation, the calculation allows a deduction equal to the notional tax that would have been payable on previous lump sums, using current tax tables rather than the rates that applied when the earlier lump sums were received.
This methodology has attracted criticism. Where tax-free thresholds have increased over time, the notional deduction may be lower than the tax originally paid, resulting in incomplete relief for taxpayers whose current tax rate is for taxpayer’s historic lump sums
Strategy to minimise tax at retirement: Using the tax-free lump sum
On retirement, a taxpayer is generally required to use at least two-thirds of their retirement fund value to purchase an annuity, whether in the form of a life annuity or a living annuity. Up to one-third may be commuted as a lump sum.
Given that up to R550,000 of a retirement fund lump-sum benefit may be received tax-free (subject to the cumulative rules), many retirees choose to apply this amount to settle outstanding debts, such as home loans or other liabilities. Even where no debt exists, the lump sum is often used to fund lifestyle objectives, including travel or the acquisition of a retirement residence.
Using Excess Contributions to Enhance Tax
Taxpayers who have made retirement fund contributions in excess of the limits allowed under section 11F may carry those excess contributions forward. These amounts can be set off against tax payable on future lump-sum benefits or, at the taxpayer’s election, against taxable income in subsequent years.
This strategy is commonly used by high-income earners in the latter stages of their careers. While the deduction for the contribution is deferred, the underlying retirement fund investments grow tax-free. Over time, the benefit of compounded, untaxed growth can materially enhance overall tax efficiency.
Conclusion
Lump-sum taxation is a distinct and often misunderstood component of the South African income tax system. While preferential tax tables and tax-free thresholds offer meaningful relief, the cumulative nature of the regime and the interaction with prior lump sums can significantly affect the ultimate tax outcome.
A clear understanding of the different categories of lump sums, their respective tax treatments, and the policy considerations underpinning the regime is therefore essential, particularly for taxpayers approaching retirement or contemplating early access to retirement savings
Dawid is a tax professional at AJM with a focus on corporate income tax and international taxation. His work centres on the taxation of trusts, corporate structuring, and trust law, with a particular interest in complex and cross-border tax issues.