How a deferred compensation scheme works

Mike asks: I am 60 years old and can work until the age of 65, but because of the current employment situation, I may have to retire sooner.

I have a stated benefits pension from a good scheme which has performed well in the past. I also have a deferred compensation policy, on which tax will be payable.

I would like to put off paying tax for as long as possible. What is the best way to invest the matured amount to prevent paying tax immediately and still get a cash benefit upfront?

Maya replies: According to Dave Crawford, independent financial adviser, this deferred compensation policy is owned by your employer. When you retire, or in your case, any time from now, you may request that your employer pay you the policy proceeds. If you are able to retire at 65 you will only be required to take the proceeds then.

At the time of leaving a deferred compensation scheme a retiring employee is required to take the entire amount in cash. The first R30 000 is available tax-free (Section 10(1)(x) of the Income Tax Act) but this will soon (from after the 2010 2011 Tax Year) be considered part of the tax-free amount available on retirement.

The details of such changes have not yet been published so the existing rules apply for now. Any excess over the R30 000, up to a maximum of three times the annual average taxable income over the past three years, will be taxed at the greater of the average tax rate in your year of retirement, or that of the previous tax year. If there is any excess it will be taxed as income, at your marginal tax rate in the year of withdrawal.

The only way to defer tax on a deferred compensation scheme is to postpone retirement for as long as possible.

You may also ask for the policy itself instead of cash and your employer will cede ownership of the policy to you. The tax will not change but having ownership of the policy means that you can make partial capital withdrawals of cash from the policy from time to time. Provided these are not regular they will not be subject to income tax but they may attract capital gains tax.

If you do not take cash or the policy from a deferred compensation scheme at retirement you create a tax problem. Let’s say you do not take the policy proceeds at retirement and come back five years later and ask for the policy, an employer-employee relationship no longer exists, and Sars may charge you tax on the proceeds as though the entire amount was taxable as income.

Read more news, blogs, tips and Q&As in our Smart Money section. Post questions on the site for independent and researched information

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Maya Fisher French
Guest Author

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