Q&A: How does tax-free severance pay work?
The severance benefit is taxed according to the retirement fund lump sum and severance benefit table in the Income Tax Act
Q: In the BusinessLIVE article “Be aware of tax you’ll pay on a severance package” published on April 26 there is reference to the first R500,000 of severance benefits paid on retrenchment being tax free. But how does this work in practice? Will my employer apply normal tax to the notice pay, severance pay and leave pay, or will it apply to the R500,000? Is the tax-free amount only applied when you are assessed? I do not know how long I will be out of work, but I expect to be without an income for at least some time. Will this not reduce my tax? Would it be better to keep the R500,000 tax free for any retirement benefits I need to access should I need to before I find work? And if I don’t need it, to use it when I reach retirement rather than use it on the severance benefits? — Anon via e-mail
A: Jenny Gordon, head of technical advice for investments, product and enablement at Alexander Forbes, replies:
When you are retrenched, by law your employer must provide a severance benefit of at least one week of salary for every completed year of service and at least four weeks’ notice if you have been employed more than a year. Some employers pay more.
In addition, on leaving employment, you will often be paid out for arrear leave.
The severance benefit is taxed on the retirement fund lump sum and severance benefit table in the Income Tax Act, which states that the first R500,000 is tax free. However, the amount you receive is aggregated with all other severance benefits and retirement lump sums you have previously received.
The arrear leave and notice pay is taxed as normal income on the Pay As You Earn (PAYE) tax tables. The net amount will be paid to you.
When paying the severance benefit, your employer will complete an IRP3(a) to apply for a tax directive on the severance benefit and the R500,000, or the balance of it if you have taken such a benefit or retirement fund lump sum previously, will be applied.
If you have never taken a severance benefit or retirement lump sum before, the R500,000 tax-free benefit will be applied to your severance benefit and you do not have a choice to rather use it against a later retirement fund lump sum.
For example, assuming the severance benefit is R300,000. This amount will be tax free and you will have only R200,000 of the tax-free allowance left when you later withdraw or retire from your retirement fund.
However, if the severance benefit is greater than R500,000 — for example, R700,000 — then the first R500,000 will be tax free and the balance taxed at 18%. If you then withdraw from your retirement fund on account of retrenchment, the amount will be taxed at higher tiers of the retirement table. In this case, the next R350,000 taken will be taxed at 27% and anything above that at 36%.
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