Retirement benefits schemes are very efficient tax savings vehicles that allow tax free accumulation of members’ benefits. Simply put, contributions made to a registered retirement arrangement are exempt from pay-as-you-earn (PAYE) tax. The investment income earned by the fund is also tax exempt.
These tax incentives are meant to encourage members to save more for their retirement as well as discourage early access of benefits before reaching retirement age.
In registering an occupational pension scheme, an employer applies for tax exemption so that tax relief is received on any allowable contributions made into the scheme. The employer therefore deducts the contribution from a member’s gross pay before calculating tax.
Contributions subject to tax relief are limited to a total of Sh20,000 per month (Sh240,000 per annum) or 30 per cent of gross pay, if this is lower than Sh20,000.
Where both the member and the employer’s contributions are jointly allowable up to this maximum limit, the member’s contributions enjoy the deductible before the employer’s contribution.
To illustrate the impact of the tax relief on the contribution, let’s look at an example where PAYE is calculated as 30 per cent of all income (in reality, there is a sliding scale for PAYE with the 30 per cent tax bracket applying on income above Sh47,059 per month). Let’s assume that Tom earns a salary of Sh100,000 per month. His net pay, after deduction of PAYE, is thus Sh70,000. If Tom decides to contribute Sh20,000 to a registered pension scheme, his PAYE will then be calculated on his salary after deducting the contribution.
The PAYE would thus equal 30 per cent of Sh80,000 which is Sh24,000. In this example, his net take home pay would drop to Sh56,000 from the Sh70,000 he took home before he started making the pension contribution. Although he takes home Sh14,000 less every month, he is actually saving Sh20,000 per month in his pension scheme.
Tom also enjoys a Sh6,000 reduction in his tax bill each month. Contributions made within the tax limit are called registered or tax allowable contributions.
These funds accumulate tax free. The investment income is exempt from taxes to encourage the build-up of benefits and generate more funds for reinvestment. What happens when pension contributions exceed the maximum limit? You can contribute as much as you like to a retirement scheme.
Contributions exceeding the tax limit are called unregistered or non-tax allowable contributions. Unregistered contributions receive no special treatment — there is no relief on PAYE and the investment income on unregistered contributions is also taxed.
For example, if you contribute Sh50,000 every month into a retirement arrangement, a maximum of Sh20,000 will be considered registered contributions and the balance is unregistered.
The relief on pension contributions serves the purpose of delaying consumption and encouraging savings. So, what’s the catch? While a member reduces his tax bill while saving in a retirement scheme, taxes will be payable when the member accesses his savings.
The benefits payable to a member in an occupational pension scheme may be subject to taxation depending on the reason for leaving the scheme, the age of the member and the length of the member’s pensionable service.
First, monthly pension or lump sums paid to a member who is 65 years of age and above is exempt from tax Tip: don’t access your benefits before reaching that milestone. No tax is payable when savings are transferred between different retirement schemes, only when the funds are actually accessed by the member. Taxes are payable on accessing registered funds, unregistered funds have already been taxed and no further tax is payable when accessing them.
When it comes to taking a cash lump sum, the following tax-free allowance applies. For every complete year of pensionable service with the employer, a tax-free amount on withdrawal of Sh60,000 is allowable subject to a maximum of Sh600,000.
With respect to a monthly pension, the tax-free allowance is Sh300,000 per annum (or Sh25,000 per month tax-free)
Table I below shows the progressive tax bands that apply to members who have attained the age of 50 years or who have more than 15 years of pensionable service in the scheme, subject to the tax-free amount.
The same tax bands will apply to your annual pension in excess of the tax-free amount.
Table II shows the tax rates for members who leave service before reaching 50 years and with less than 15 years of pensionable service in the scheme.
You will notice that the taxation of benefits for members who are withdrawing from the scheme before attaining 50 years and with less than 15 years of pensionable service is more penal than for a member who has attained the age of 50 or who has more than 15 years of pensionable service in the scheme. The purpose of the structure above is to encourage members to preserve their benefits until retirement age or 65. Remember, members above the age of 65 are tax exempt.
In summary, retirement benefit arrangements offer attractive tax incentives. Nevertheless, decisions taken by members in preserving their benefits play a big role in how far they can exploit the tax regime to their advantage.
Adil Suleman, Head of Actuarial Division at Zamara, [email protected]