Money or the box?

Money or the box?

It is incredible how often the same “issue” or question comes up in quick succession…just this week 2 clients have both asked about cashing in their preservation funds to try to use the funds elsewhere – 1 to invest the funds into her bond and the other to invest the money into a share portfolio. This article will deal with the tax implications of doing this (we will explore the merits of this at a later stage)*.

For those that are not familiar with preservation funds they are essentially a vehicle into which can transfer your pension or provident fund if you leave your employment before retirement…the money is invested into some unit trust (or similar) funds and will remain there until such time as you reach retirement age. In other words, your pension fund is “preserved”. The transfer is “tax neutral” i.e. there is no tax on the transfer and one of the attractive options available with a preservation fund is the “once-off” withdrawal option. This is done before retirement age and can be a portion of the fund or the full amount.

Currently if you withdraw from your preservation fund before retirement you will receive the first R22500 tax-free. The balance of the amount will be taxed according to the “pre-retirement” tables with the next R577500 being taxed at 18%, the next R300000 at 27% and the balance at 36%. Not too bad you might think…and indeed it isn’t, right now. But the problem comes at retirement when you want to take the 1/3 lump sum out of your fund…any amount that you have taken out before retirement will be taken off the tax-free portion available to you at retirement (currently the first R300000 is tax free at retirement).

To illustrate the effects of the tax, let’s consider an example and assume that Mrs X wants to withdraw the full amount of her preservation fund which is currently sitting at R1.4million.

If she withdraws now (pre-retirement) the following should happen (based on current tax tables):

  • The first R22500 will be tax free
  • The next R577500 will be taxed at 18% (i.e. R103950)
  • The next R300000 will be taxed at 27% (i.e. R81000)
  • And the balance will be taxed at 36% (i.e. R180000)
  • So she will pay R364950 in tax and will she will leave with R1035050 to do with as she pleases (invest into her bond or into a share portfolio).

Now let’s move forward a few years to her retirement and assume that she has a retirement annuity and/or pension fund with her current employer and that the value has grown to R3million (it is an amount that easily divides by 3). Under current legislation she is entitled to take up to R1million out of the fund and do with it as she pleases. If she had not taken anything from her preservation fund she should get the following:

  • The first R300000 would be tax-free
  • The next R300000 would be taxed at 18% (R54000)
  • The next R300000 at 27% (R81000)
  • And the balance of the million would be taxed at 36% (R36000)
  • All told she would pay R171000 in tax and she would walk away with R829000 (or she could even limit her withdrawal to the R300000 tax-free and leave the balance in the fund to increase the annuity she receives).

Unfortunately for her, however, she took R1.4million out of her preservation fund prior to retirement and as a result, this amount will be taken into account when the tax is calculated on the 1/3 withdrawal. As a result, anything she takes out of now will be taxed at 36% (the sliding scale is applied after taking into account anything she has already withdrawn from her retirement funds). So if she does withdraw R1million at retirement she would effectively lose R360000 in tax – the entire tax-free portion has been used up prior to retirement and the sliding scale kicked in and is now applied at 36%.

As a result of taking a pre-retirement draw from her funds she effectively forfeits R277500 tax free money (she got R22500 from the pre-retirement withdrawal).

Let’s consider another example where Mr Y takes R300000 out of his preservation fund prior to retirement. His tax calcs will look something like this:

  • The first R22500 will be tax free
  • The next R277500 will be taxed at 18% (i.e. R49950)
  • So he should pay R49950 in tax and should leave with R250050 to do with as he pleases.

Now let’s skip forward a few years to retirement and again assume a pension fund of R3million and that he wants to take out 1/3 as a lump sum. His tax calculations should look something like this:

  • The first R300000 (tax-free) has been used up (pre-retirement) and so the sliding scale should kick in immediately with the first R300000 being taxed at 18% (R54000)
  • The next R300000 at 27% (R81000)
  • And the balance of the million would be taxed at 36% (R144000 – 36% of R400k)
  • All told he should pay R279000 in tax and he should walk away with about R721000.

It should be clear from these 2 examples that from a tax point of view it does not pay to make early (pre-retirement) withdrawals from your preservation or pension funds – and we have not even got into what you would have to invest in order to replace the money taken out.

Note: * the above examples are for illustration only and should not be relied upon for advice. You should get a professional tax opinion before making these decisions.