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Introduction

The early withdrawal of retirement benefits before you retire not only reduces the tax free lump sum which is available when you retire. It also results in a higher tax rate for the benefit that you eventually take when you retire.

The deferral of the withdrawal of your retirement benefits can therefore help to decrease your total tax liability when you retire.

Current tax tables applicable to retirement benefits

Withdrawals prior to retirement

Amount

Rate

First R22,500

0%

R22,501 - R600,000

18%

R600,001 - R900,000

27%

Above R900,000

36%

Withdrawals at retirement

Amount

Rate

First R315,000

0%

R315,001 - R630,000

18%

R630,001 - R945,000

27%

Above R945,001

36%

Example 1 – Withdrawal of retirement benefits

Mr Poundfoolish starts working when he is 25 and he contributes to his employer’s pension fund. He resigns when he is 34 and he decides to withdraw his retirement benefits of R250,000. Because it is a pre-retirement withdrawal only the first R22,500 is tax-free and the remaining R227,500 is taxed at 18% which amounts to R40,950.

He immediately starts working at a new employer and he contributes again to the employer’s pension fund. He resigns when he is 45 and he again decides to withdraw his retirement benefits of R350,000. However, because he has already withdrawn R250,000 these two amounts are added together to calculate the total tax liability. The first R22,500 is again tax-free, and he is then taxed at 18% on the remaining R577,500 which amounts to R103,950. The tax of R40,950 which he paid on the first withdrawal is then deducted from the R103,950 which gives hom a total tax liability of R63,000 on the second withdrawal.

The negative effect of these two withdrawals appear when Mr Poundfoolish eventually retires at 65 and his final retirement benefit at his last employer is R500,000. Because he has already withdrawn retirement benefits of R600,000 he has to pay tax at the above-mentioned rates on the R500,000 lump sum withdrawal which amounts to R153,000.

When the two previous tax liabilities of R40,950 and R63,000 are added to the R153,000, the final tax paid amounts to R256,950 at an effective tax rate of 23% (R256,950 ÷ R1,100,000).

Example 2 – Preservation of retirement benefits

Mr Pennywise starts working when he is 25 and he contributes to his employer’s pension fund. He resigns when he is 34 and he decides to transfer his retirement benefits of R250,000 to a preservation pension fund. There are no tax implications for this transfer. 

He immediately starts working for a new employer and again contributes to the employer’s pension fund. He resigns when he is 45 and he again decides to transfer his retirement benefits of R350,000 at that stage to a preservation pension fund. There are again no tax implications for this transfer. 

The positive effect of these two preservation pension funds appear when Mr Pennywise eventually retires at age 65 and his final retirement benefit at his last employer amounts to R500,000. Because he has not made any withdrawals of retirement benefits previously he can withdraw the first R300,000 of his consolidated fund value of R7,653,211 tax-free.

He subsequently withdraws only R300,000 of his consolidated fund value and he invests it in a money market fund at an interest rate of 6% per year. He invests the remaining R7,653,211 in an Investment Linked Living Annuity (‘ILLA’), with no tax implications on any of these two events.

He receives interest-income of R18,000 per year on the money market investment (his only interest-producing investment) and he does not pay tax on this as the first R32,000 of interest income is tax-free for individuals older than 65. He further decides to withdraw only 2.5% of his fund value of his ILLA as a pension and this amounts to R183,830 per year.

Based on the 2010/11 tax tables he is going to pay income tax of R20,222 on his total annual income of R201,830 at an effective tax rate of 10% (which is considerably less than the 23% which Mr Poundfoolish had to pay on his withdrawals).

Conclusion

By making informed decisions Mr Pennywise can:

  • save income tax of R256,950 which Mr Poundfoolish has to pay on his withdrawals;
  • increase his eventual retirement benefits fund value materially with approximately R1,209,841; and
  • minimise his total income tax liability on his retirement income materially by structuring his investments smartly.

The examples above also smashes the common argument that individuals do not invest in retirement funds or retirement annuities and utilise the massive annual tax deductions because they “will eventually pay tax on the income anyway”.

Please contact us if you have any questions regarding the above, or about retirement funds in general.