Nedgroup Investments : Guard against early withdrawals from retirement funding

Far too many South Africans grow old with absolutely no provision for retirement. Our government has become increasingly serious about encouraging people to save for old age by providing tax benefits to those who do save and rather harsh penalties to those who try to access the money early. One of these penalties is levied via the taxation of lumpsum benefits taken prematurely from a retirement fund whereby the penalty is actually quite onerous and means that you forfeit taking a very valuable and quite large tax free lump sum when you do retire. Some of the other unintended consequences of dipping into your retirement funding is also a loss of capital growth and the power of compounding and all those good things that come to patient investors. The bottom line from Denver Keswell, senior legal advisor at Nedgroup Investments, is to try and avoid touching your retirement fund prior to retirement. – Candice Paine

This special podcast is brought to you by Nedgroup Investments.  I’m sitting in the offices of Nedgroup Investments with Senior Legal Advisor, Denver Keswell, and today we are speaking about the taxation of lump sum withdrawals from your Retirement Fund.  Denver we were chatting just before we started recording this podcast and you said some really interesting things around the penalisation of actually withdrawing from your Retirement Fund prior to actual retirement.  Can you talk a little bit around that?

Sure, Candice.  Effectively, when you exit/leave a Retirement Fund and you receive a lump sum from there, it can only be taxed in one of two ways.  It will either be taxed as a withdrawal and you would apply the withdrawal table or it will be taxed as a retirement benefit and therefore, you’ll apply your retirement table.  I think it’s fairly simple and everyone understands how the taxation works when you have one event.  It’s very simple.  When you resign from employment and you decide to take a cash lump sum instead of preserving that benefit, then you would apply a withdrawal table and it’s very simple to just put that benefit into the withdrawal table and calculate your tax.  If you’re at retirement and you decide to commute a portion of your benefit (you take one-third, for example), you would apply the retirement tables on that lump sum and therefore, retirement tax would apply.  That’s fairly simple. I think the complication comes in with what is often referred to as the cumulative principle /accumulation principle.  That was introduced back in 2009 and the Nett Effect of what it actually does is this.  If you access your Retirement Fund prior to retirement, the Nett Effect means that the tax benefits that you are entitled to when you get your retirement will actually be reduced.  What do we mean by that?  You can’t just apply the table on withdrawal and then just use the normal retirement table as though there wasn’t a withdrawal.

Therefore, if you’ve used up a portion of the tax benefit due to you, you can’t claim it again when you actually do retire.  Is that what you’re saying?

That’s the Nett Effect of the cumulative principle, Candice.  For example, if you took R100k …  You’ve decided to resign from employment, you needed R100k, and you decided to transfer the rest to a Preservation Fund, then that R100k is a withdrawal benefit and it needs to be taxed in terms of the withdrawal table.  Currently, you would be entitled to R25k tax-free and the remaining R75k would be taxed at 18 percent so you have paid tax on withdrawal.  When you get to retirement and you decide to commute a benefit for example, ‘one-third/two-thirds, assuming your lump sum benefit is more than R1m’, normally you would be entitled to R500k tax-free.  In our example, because you’ve taken R100k as a withdrawal benefit, that would have the effect of reducing your tax-free benefit.  Instead of getting R500k tax-free, you’d only be entitled to R400k tax-free.

Okay, and you would have paid more tax because you only had R25k with the first withdrawal.

Correct.

Okay, so this is a huge disincentive for people to take money prior to retirement.  Is that correct?

Absolutely, and I don’t think it was a mistake by Treasury.  When you save towards retirement, the point of saving towards retirement is actually to provide an income when you do retire.  This was a way to dis-incentivise individuals from actually trying to access their retirement benefits prior to retirement.  Believe it nor not; one of the events for which you can access your Retirement Fund is on divorce.

That’s right.

Weirdly enough, we actually saw some individuals who got divorced just to access their Retirement Funds.  This was one of the ways that Treasury said ‘we give you all these tax advantages.  We give you the tax advantage going into the fund through tax deduction.  Whilst you’re in the fund, there’s no tax table and when you come out, we give you certain tax concessions.  However, if you’re not going to use this benefit as a retirement benefit, then you shouldn’t be entitled to all of this.’ So yes, it has the effect of penalising in the sense that you’re almost deemed to have received those tax benefits when you took the withdrawal.  Looking at another example, if the client actually took R500k from a Preservation Fund or on resignation; that’s a withdrawal benefit of R500k.  When they get to retirement, that individual is deemed to have received their R500k tax-free, even though they only got R25k tax-free on the withdrawal.  It would mean that essentially, the entire R500k tax-free benefit would be lost to that client and they would be taxed from the next bracket, which is 18 percent.

Okay, so what you’re saying is, absolutely, under no circumstances, should you access your retirement benefits before retirement, because you’re going to be penalised.  How does this tie in with Treasury’s thinking around the tax-free savings account?  It seems as though Treasury is really making an effort to get people to save.

I think that the tax-free savings account was the result of Treasury realising that we can provide individuals with all these tax benefits in Retirement Funds.  The simple truth is that a client might be faced with an event where they desperately need cash and if they do need cash prior to retirement; they shouldn’t try to find ways to access their funds from a Retirement Fund.  What’s nice about tax-free investments is that it obviously gives you great tax incentives (not as good as Retirement Funds, obviously) but it also allows you to access those funds, should you require them.

Okay, so it’s probably a way for somebody to have a savings account for the proverbial ‘rainy day’ where they don’t actually need to access their Retirement Fund and lose/use up a portion of that R500k tax-free amount that they would get on retirement.  Let’s talk a little bit about that R500k.  How often is that reviewed by SARS?  Where have we come from, what’s the history of it, and will we get it grow?  Those would obviously be people’s questions.

That’s a good question.  It comes up often.  When I started in the industry, there was this really strange way to calculate your tax-free benefits on a lump sum.  If I remember correctly, it was Z=C+E-D.  It was something really weird.  In any event, at that stage you were entitled to R120k tax-free on a Retirement Annuity.

Can we ask you when you started in the industry?

I think I started in 2004/2005.

Okay, so it’s moved quite quickly.

They actually replaced that calculation with this retirement table and when they first introduced it, it was R300k tax-free.  A few years later, they changed it to R315k tax-free and I think it’s been about two or three years now, in which it’s been R500k tax-free.

Okay, so SARS has been quite generous with that tax-free amount.  Your message to people is probably not to abuse it and to try to refrain from accessing those funds, if at all possible.

Absolutely.  Some people who decided to take a withdrawal did so when the tax benefit was R315k and they thought ‘well, it isn’t that high’ and then, when it changed to R500k, they thought ‘surely, I don’t lose the R185k’.  Unfortunately, that’s not how it works.  If you had taken more than R500k as a withdrawal benefit, the Nett Effect is you start from that amount, using your retirement table.

Okay.  Denver Keswell, Senior Legal Advisor at Nedgroup Investments.  We’ll try our best to refrain from making early withdrawals from our Retirement Funds.