A disallowed contribution is a contribution that did not previously qualify as a tax deduction. To understand what was not allowed, one first needs to understand what is allowed.
Sections 11F(1) and (2) of the Income Tax Act allow a member who contributes to a pension, provident or retirement annuity fund to deduct a specified maximum amount from their annual taxable income. The deductible amount is the lesser of:
limited in all cases to the actual contributions made by or on the member's behalf (employer and member contributions combined).
For a member with a single source of income, the maximum deduction is 27.5% of their salary, capped at R350,000 per annum. The tipping point — the remuneration or taxable income required to qualify for the R350,000 maximum — is R1,272,727.28.
Employer contributions paid for the benefit of an employee are deemed to be employee contributions and are taxed as fringe benefits in the member's hands under paragraph 2(l) of the Seventh Schedule to the Income Tax Act.
Section 11F(3) of the Income Tax Act provides that any amount contributed to a pension, provident or retirement annuity fund in a previous year of assessment that was disallowed solely because it exceeded the maximum deduction for that year is deemed to be a contribution in the current year of assessment, except to the extent that it has already been: (a) allowed as a deduction against income; (b) accounted for under paragraph 5(1)(a) or 6(1)(b)(i) of the Second Schedule; or (c) taken into account under section 10C.
There are two carryover mechanisms for non-deductible contributions:
Contributions to a provident fund were not tax-deductible before 1 March 2016. The alignment of the tax treatment of contributions, which came into effect on 1 March 2016, resulted in all contributions made to contributory retirement funds qualifying for a deduction in the year they were made. A provident fund member therefore did not have pre-1 March 2016 contributions that were disallowed because they exceeded the maximum deduction for that year. Accordingly, no rollover from pre-1 March 2016 provident fund contributions to a following tax year is permitted. This was confirmed in the Final Response Document on the Taxation Laws Amendment Bill, 2016 of 15 December 2016, which rejected the harmonisation argument on the basis that allowing provident fund members to roll over historical contributions would provide a deduction on amounts for which there is no corresponding requirement to annuitise on retirement.
A contribution that did not qualify as a deduction at all — as distinct from one that was deferred — may still be carried over and deducted from a member's lump sum benefit under paragraph 5 or 6 of the Second Schedule. Such contributions are those that formed part of the contributions taken into account under section 11F in the specific year of assessment but were simply not allowed as a deduction in that year because the member's taxable income in that year was insufficient.
Members are not always aware that a contribution made in a specific tax year does not qualify for a full deduction under section 11F in that same year. The maximum allowable deduction depends on the member's remuneration or taxable income, which SARS can only assess in the next tax year — and depending on when the member submits their return, the assessment may only be finalised by November or December of the following year.
As a result, it is not possible to determine during the current tax year how much of that year's contributions will qualify for a deduction and what portion will constitute disallowed contributions. The maximum allowable deduction and the disallowed amount for a specific tax year are both based on the member's taxable income and contributions made in the previous tax year.
The carryover of excess contributions is automatically accounted for in the member's annual tax assessment. SARS calculates the deductible amount each year, taking into account current-year contributions, taxable income and any carried-over amounts from previous years. The carryover is reflected on the member's ITA34 — Notice of Assessment.
When the fund applies for a tax directive on a retirement fund lump sum benefit or retirement fund lump sum withdrawal benefit, SARS will include only the disallowed contributions as at the end of the previous tax year. Any contributions made in the current year will be included in the next tax year's assessment.
The member does not have a choice as to how and when disallowed contributions are taken into account. When a member exits a retirement fund and takes a lump sum benefit, the disallowed contributions across all funds to which the member has contributed are added together and deducted from the first lump sum that becomes payable — irrespective of whether those contributions were made to that specific fund. The applicable tax table is then applied to the balance.
Paragraph 2(1)(a) of the Second Schedule, read with paragraph (e) of the definition of "gross income" in section 1 of the Income Tax Act, confirms that a retirement fund lump sum benefit is the amount received less any deduction under paragraph 5 or 6 of the Second Schedule. Specifically:
The amount taxed on the applicable tax table is therefore the member's fund benefit after the disallowed contributions have been deducted. A retirement fund lump sum benefit is taxed on the retirement tax table (first R550,000 at 0%); a retirement fund lump sum withdrawal benefit is taxed on the withdrawal tax table (first R27,500 at 0%).
On retirement, a member must use their retirement component and at least two-thirds of the non-vested benefit in their vested component to purchase an annuity, subject to the de minimis rule. If the combined value of two-thirds of the member's non-vested benefit in their vested component plus their total retirement component is less than R165,000, the member may take the total retirement benefit as a lump sum.
The disallowed contributions must first be deducted from the retirement fund lump sum benefit and then the tax is calculated on the balance. If the taxable retirement fund lump sum benefit after deducting disallowed contributions is less than the portion of the lump sum that would otherwise be taxed at 0%, the member effectively forfeits some of the tax-free portion — unless they also take a retirement fund lump sum benefit from another fund.
Any disallowed contributions not applied against a lump sum qualify for exemption against the member's annuity income under section 10C(2) of the Income Tax Act. The exemption covers contributions that did not rank for a deduction under section 11F and have not previously been allowed as a deduction under the Second Schedule or exempted under section 10C in a prior year of assessment.
When a member dies, the trustees of the fund must decide how to distribute the death benefit. Each beneficiary may choose to receive their allocated portion as a lump sum, an annuity, or a combination of both.
Lump sum: Paragraph 3 of the Second Schedule deems a lump sum payable on a member's death to have accrued to the member immediately prior to death. It is taxed in the hands of the deceased on the retirement lump sum tax table, after the deduction of disallowed contributions under paragraph 5 of the Second Schedule. Section 3(3)(e) of the Estate Duty Act No. 45 of 1955 deems those contributions allowed as a deduction under paragraph 5 of the Second Schedule to be property of the deceased. Accordingly, disallowed contributions qualifying as a deduction will be included as deemed property in the deceased member's estate and will be subject to estate duty.
Annuity: The section 10C exemption applies only to a compulsory annuity taken out by the member on their own retirement. It is not available to a beneficiary who opts to receive their allocated portion as an annuity.
When an annuitant dies, the balance of their living annuity or the remaining guaranteed portion of a life annuity is paid to nominated beneficiaries (or, in the absence of nominees, to the deceased's estate). Beneficiaries may choose a lump sum, an annuity, or a combination.
Lump sum: Paragraph 3 of the Second Schedule also applies to lump sums on the death of an annuitant. The lump sum is taxed in the hands of the annuitant, not the beneficiary. Any disallowed contributions that did not qualify as a deduction against the member's retirement lump sum under paragraph 5 or as an exemption under section 10C against their annuity income during the annuitant's lifetime are available as a deduction against the lump sum payable to a beneficiary. Those contributions allowed as a deduction under paragraph 5 will be included as deemed property in the deceased annuitant's estate and will be subject to estate duty under section 3(3)(e) of the Estate Duty Act. Because disallowed contributions are always calculated in arrears, this may delay the finalisation of the annuitant's estate.
Annuity: If a beneficiary opts to use their allocated portion to purchase an annuity, that beneficiary cannot claim any disallowed contributions not utilised by the annuitant during their lifetime as an exemption under section 10C. In that case, the disallowed contributions are not a deemed asset in the deceased annuitant's estate and do not attract estate duty.