Approved or unapproved death benefits – beware of hidden tax implications for loved ones

Knowing whether your death benefits are approved or unapproved in terms of the Pension Funds Act may save your loved ones from any unexpected tax surprises at an already difficult time.

“The nature of death benefits rarely gets enough attention from ‘the living’ but the tax implications of this benefit can become a substantial burden on the beneficiaries you intend providing for,” says Celeste Kruger, Consultant – Employee Benefits Consulting, GTC.

Death benefits from retirement funds are subject to the requirements of Section 37C of the Pension Funds Act, and they are taxed in terms of the Second Schedule of the Income Tax Act (see scales at the end of the article).

“Most employers provide for a death benefit – usually a lump sum amount – to employees in addition to a retirement benefit. But the way in which this benefit is structured, determines the tax treatment thereof in the event of death.” Kruger explains.  “In most cases, employers would include the premiums in respect of death benefits in the contributions to the retirement fund. This is referred to as an ‘approved’ benefit, meaning it is recognised by the Registrar of Pension Funds and approved by the Commissioner of the South African Revenue Service (SARS) for tax deduction purposes.

Kruger adds that should the employee pass away whilst in service of the company, the death benefit will be paid to the deceased’s dependants or nominees as agreed by the Trustees, through the retirement fund. However, since it is paid from the retirement fund, it will be deemed to form part of the retirement benefit, and therefore it will be taxed.

“The implication is that the deceased employee’s dependants or nominees may receive considerably less of the expected benefit, due to the tax deduction, on any pay out greater than R500 000,” she continues. “This reduction may be quite significant, depending on the quantum of death benefits received.”

She says that the beneficiary may choose to utilise the death benefit to purchase an annuity – instead of receiving the lump sum.

“In this instance, the benefit will not be taxed upfront, but considered as income drawn over time, and taxed according to Pay As You Earn (PAYE) tax tables.”

How to avoid this tax liability

According to Kruger it is possible to avoid this tax liability at death.

“An employer may provide death benefits directly through an insurer, by paying the premiums to a separate employer-owned group life assurance policy, instead of to the retirement fund. These are referred to as unapproved benefits, and are not recognised as a retirement benefit by either the Pension Funds Act or SARS,” she says.

“The benefits will still accrue and pay out. This time, however, the benefits will be tax-free in the hands of the appointed beneficiary. The employee will be taxed on the monthly contributions towards the unapproved group life assurance, as this will be deemed a fringe benefit provided by the employer and therefore considered as part of gross income.” Added to this, the beneficiary appointment will be unencumbered by the Section 37C Pension Fund Act limitations on the selection of dependants or beneficiaries.

If the benefit is considered a fringe benefit, the employer will be able to deduct the premiums from its income, for tax purposes.

“What may seem like a trivial detail, can have a major impact at a difficult time, so we encourage employees to find out what their death benefit status is, and specifically whether it is approved or unapproved. This would enable them to prepare their affairs accordingly and provide their dependants with peace of mind,” Kruger concludes.

Tax scales of the Second Schedule of the Income Tax Act:

Tax on lump sums on retirement, retrenchment and death
1st R500 000 Tax Free
R500 001 – R700 000 18% of the amount above R 500 000
R700 001 – R1 050 000 R36 000 + 27% of the amount above

R700 000

R1 050 001 + R130 500 + 36% of the amount above

R1 050 00

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