I recently received an inquiry regarding various types of annuities, and
the tax implications.
Firstly, what is an annuity? It is generally accepted
as being an amount paid or received on a regular basis.
It would not, however, include an amount which is a payable as a fixed lump
sum, but which is simply settled over a period of time.
There is a clear
distinction between the two types of payment. Income tax legislation specifically includes any amount received or accrued
by way of annuity income in gross income. Thus, in general, annuities will
always be fully taxable on receipt.
Examples of annuities would be amounts
received in terms of retirement funds, for example monthly pension
payments, annuities paid in terms of a requirement in a trust deed (this
often arises as a consequence of a will).
There is, however, an exception which relates to purchased annuities -
those bought in terms of an annuity contract with an insurer. This only
applies to annuities bought by natural persons, not companies, close
corporations or another entity.
In terms of these types of contracts, the insurer agrees to pay to the
purchaser, or his or her spouse or surviving spouse, an annuity until the
death of the annuitant (the person specified to receive the annuity) or
until the end of a specified term. The insurer agrees to do this in return
for a lump sum. Such a contract cannot, however, relate to an annuity paid
from a pension, provident or retirement annuity fund.
The effect of the section is to exempt from tax the portion of the annuity
which represents the return of the capital lump sum invested. Thus, the
legislation presupposes that a portion of each annuity contains a small
portion of the original capital invested, and since, upon its return, this
would not be taxable if a normal investment had been made it will not be
taxable in this instance.
If you purchase such an annuity, the capital portion of the annuity will be
calculated by the insurer and, when you are given your IRP5 certificate
reflecting the tax that has been withheld by the insurer from the annuity,
it will reflect the amount of the total annuities paid to you during the
year that represent the portion of the capital sum you have paid to
purchase it.
If you would like to check the calculation, you will need to apply the
following formula: Y = A/B x C where A is the total cash consideration you paid for the annuity, B is the
total of all the annuities you expect to receive over the full period of
the annuity contract and C represents the annuities you have received in
the tax year.
If the contract is related to a person`s life period, you will need to
establish the period needed to determine B in the formula by establishing
the person`s life expectancy from the life expectancy tables. (These tables
distinguish between male and female and determine life expectancy based on
current age.) If there is uncertainty as to the period, ask your insurer to
explain how the calculation has been done because there are various other
criteria that need to be established. The insurer`s actuaries will have
performed the calculation but will also have complied with certain formulae
that are set out in the legislation.
The important thing to remember is that, when you complete your income tax
return, you need to distinguish between the taxable portion of the annuity
and the non-taxable capital portion as reflected on the IRP5.