OPTIMISE YOUR RETIREMENT FUND CASH LUMP SUM – WHAT AND HOW?

From PAYE to Vat to CGT, tax will erode your retirement savings if you let it. Here’s how what you invest in now determines how much Sars takes in retirement.

I want to start way back before retirement.

We all know the tax burden we face each month. We are not only subject to income tax (PAYE), but everyone (including low-income earners) also has to pay value-added tax (Vat) on goods purchased and capital gains tax (CGT) on assets sold. CGT has a tendency to unexpectedly push people into higher tax brackets. All in all, we are faced with taxes for our entire lives.

We should all strive to pay as little tax as possible once we are retired. We also need to find the most tax-efficient ways to invest to pay as little tax as possible. Taxes can erode long-term returns substantially. I am not promoting tax evasion, but tax avoidance is perfectly legal.

The most efficient way to ensure you pay minimal tax on the day you enter retirement is to allocate sufficient funds during your lifetime to voluntary funds/investments (also referred to as discretionary funds/investments).

Why do I say this? Consider the following:

1. Retirement funding is an effective way to save and grow wealth. Contributions are tax-deductible within certain limits, and when these limits are exceeded, tax-free income can be drawn from your pension from the day you retire until the contributions that exceeded the allowed tax-deductible amount (referred to as disallowed contributions) have been paid out as income via an annuity.

Retirement funds are tax-exempt, meaning no income tax or CGT is payable within them. This applies to all pre-retirement products and post-retirement living annuities.

Income paid by annuities purchased with the proceeds of retirement funds is fully taxed according to the South African Revenue Service (Sars) tax tables.

When you retire, you will generally be allowed to draw a maximum of 1/3 of the capital amount of your retirement fund in cash. This is the amount referred to in the heading of this article.

When you commute 1/3 to cash, the first R 550 000 will be tax-free, and the balance will be taxed on a sliding scale. However, if there were disallowed contributions (as mentioned in the previous paragraph), the R 550 000 can be increased by the amount of those contributions.

Bear in mind that the cash commutation will be restricted to 1/3, and both the 1/3 and the tax-free portion will be aggregated across all your retirement funds.

The disallowed contributions can therefore be claimed either as tax-free income, as an increased tax-free amount under the cash commutation, or as a combination of both.

Generally, retirement funds are not highly liquid and must remain invested until the day you retire. Recent legislative changes introduced the two-pot system (which can be argued to be a three- or even a four-pot system), allowing investors to access a portion of the capital annually before retirement. Funds drawn from the cash component of the two-pot system will be taxed as income in the hands of the investor.

It is important to note that the savings component of the new two-pot system is effectively the 1/3 cash component that you can commute to cash at retirement. Any funds drawn from the savings pot before retirement will therefore reduce the cash component available at retirement.

2. Voluntary funds, on the other hand, are funded with after-tax money. Contributions are not tax-deductible. Although drawings (some investors refer to them as income payments) will not attract income tax (PAYE), they will attract CGT when sold or when the portfolio changes and there are capital gains.

During the holding period of the voluntary investment, IT3 certificates will be issued for interest earned on cash and bond holdings.

Tax on your bond holdings, income funds and cash/money market investments will be payable irrespective of whether you sold an investment or not. This is not dissimilar to cash held in a bank, where tax is paid on the interest earned.

Tax payable on voluntary funds will depend on the structure of the investment, for example:

• Funds held directly by the investor, either via a platform or directly with a fund manager, an ETF, a stockbroker, etc., will be taxed at the investor’s personal tax rate.

• Funds held via an endowment will be taxed at 30% under the insurer’s five-funds rule.

• Funds invested via tax-free investments (TFIs or TFS) are tax-exempt and will not attract any taxes.

From the above, we can conclude that the more ‘income’ is drawn from voluntary funds, the less tax will be paid, since the predominant tax payable will be CGT.

If all your funds are invested in retirement funds, you will, unfortunately, be trapped in the Sars tax net for compulsory PAYE for the rest of your life.

To determine the ideal split between voluntary funds and compulsory fund contributions, some forecasting and assumptions are required. One needs to consider tax deductions, tax payable over the term of the investment, liquidity, future income requirements, and different returns across products, taking into account asset classes and tax liabilities.

As a rule of thumb, I aim for a 50/50 split between voluntary and retirement funds by the time someone retires. This split generally provides sufficient tax deductibility for retirement fund contributions and a solid strategy to draw 50% of the required income from retirement funds and 50% from voluntary funds.

By drawing 50% of the required income from voluntary funds, approximately 25% less tax will be paid, which in turn means that less income needs to be drawn from the two sources to achieve the net after-tax income. Drawing less leads to a more sustainable investment portfolio.

After all that, what does this have to do with the article’s theme, namely optimising your retirement fund’s cash lump sum?

When you have the opportunity to receive a lump sum from a retirement fund, consider the following:

• We know that the first R 550 000 is tax-free. If your future retirement income is taxed at, say, 30%, it may pay to draw R 1.5 million and pay the 24.8% tax. The residue of some R 1 128 000 can be added to existing voluntary funds to boost the voluntary ‘pot’, so that a larger portion of required income can be drawn from voluntary funds.

• If the retiree has debt, pay it off if the savings from the monthly debt repayment will result in positive cash flow compared with the income forfeited.

• If the retiree has a disproportionately large share of their wealth in voluntary funds, consider not taking a cash commutation and instead boosting retirement funding.
  There are benefits to having retirement funding. Living annuities do not form part of your estate, and liquidity and monthly income are guaranteed to continue through beneficiary nominations. No executor or pension fund trustee intervention is required to distribute living annuity proceeds. Voluntary funds will be tied up in the estate for months, which can lead to cashflow problems for loved ones.

• Many South Africans use their cash commutation to buy a rental property for additional income. Be very careful if you consider this option. Not all properties are equal. Maintenance costs, levies, insurance, rates and taxes all detract from income, and rental income is fully taxed. Many properties also disappoint in their returns. Tenant defaults also present a challenge. If you are not familiar with property renting, take all factors and potential risks into consideration. You cannot afford to lose money in retirement.

I hope the above information helps somewhat. However, I suggest that when it comes to retirement, you consult a suitably qualified professional financial planner. You only get one shot at it, so get it right.

Most importantly, start your strategic allocation to voluntary and compulsory funds as early as possible. If your allocation is optimised, the commutation decision becomes much easier on the day you retire.

Take care