Effects of early withdrawals on retirement saving
The goal of saving for retirement is to provide an income in retirement. There are however instances when a retirement fund member can access all or a portion of their retirement benefits before retirement. Many people access these options without fully understanding the effects “early withdrawals” will have on their financial position in retirement. Not only are they reducing the fund benefits they’ll have available at retirement, but many retirement fund members are also unaware of the severity of the tax consequences.
A retirement fund member may exercise an option to withdraw from a retirement fund in the following instances:
- Resignation or dismissal from employment
- Retrenchment (though compulsory retrenchment is now taxed as a retirement benefit)
- One allowable withdrawal from a preservation fund
- Withdrawal from a retirement annuity (RA) on formal emigration
- Full withdrawal if an RA’s fund value is less than R7000
The most common types of early withdrawals are when retirement fund members resign from work, and when preservation fund members exercise their option to take their one allowable preservation fund withdrawal.
The tax impact of early withdrawals
Most people are aware that any withdrawal taken will be taxed, but not everyone fully understands the impact of the withdrawal on tax at retirement. All lump sums* received from a retirement fund are either taxed as a “withdrawal benefit” or “retirement benefit”. The following tables are used to tax retirement fund lump sums:
Withdrawal benefits taken in cash after 1 March 2009 have the net effect of reducing your tax benefits at retirement and so too do retirement benefits taken in cash after 1 October 2007.
There will be times when we are all tempted to take an early withdrawal, but it is imperative to talk to a financial planner first to understand the full implications and tax involved.
The following examples show that a fund member can pay more than double the necessary amount of tax by taking an early withdrawal from a retirement fund.
Chris resigns in October 2010 and has a pension fund worth R600 000. He decides to take R450 000 in cash and transfers the remainder to his new employer’s pension fund. Chris retires in March 2014 and his pension fund is again worth R600 000. He decides to take his allowable one third lump sum (R200 000) and purchases an annuity with the remainder.
How much tax does Chris pay on his lump sum?
Assuming Chris has no previously disallowed contributions, he will apply the rates as set out in the retirement lump sum taxation table on page 18 to his lump sum of R200 000. Instead of the first R500 000 of his lump sum being tax-free, however, Chris’s tax-free portion has been reduced by his previous withdrawal in October 2010. This means Chris has:
R500 000 less R450 000 (his previous withdrawal)
= R50 000 tax-free
The remaining R150 000 of his lump sum will be taxed at 18%
= R27 000 tax payable
What if Chris transferred his full fund value of R600 000 when he changed jobs, instead of taking a withdrawal of
Fund value = R600 000 + R450 000 (accumulated between October 2010 and his retirement in February 2014, assuming no previous withdrawals and ignoring potential returns)
= R1 050 000
One third lump sum = R1 050 000/3
= R350 000
R500 000 tax-free allowance means there is R0 tax payable.
Chris has therefore paid R27 000 more tax on retirement because of his early withdrawal. In addition, Chris would have already paid tax on this withdrawal at the time.
Jabu resigns in June 2009 and decides to take R400 000 cash from his pension fund. He transfers the remainder of his fund value (R500 000) to a preservation fund.
In August 2011 Jabu takes a full withdrawal from his preservation fund which has by then grown to R650 000.
Jabu plans to retire in November 2014 and wants to take R1 100 000 as a lump sum from the pension fund he holds with his current employer.
How much tax will Jabu pay on his lump sum?
Jabu has taken two withdrawals after 1 March 2009 which will reduce his tax benefits at retirement. The R1 050 000 combined withdrawal (R400 000 + R650 000) will eradicate his R500 000 tax-free allowance, as well as his R200 000 @ 18% and his R350 000 @ 27%. This means that Jabu’s entire lump sum at retirement will be taxed at 36%.
R1 100 000 taxed at 36%
= R396 000 tax payable
What if Jabu transferred his full fund value of R900 000 when he changed jobs and did not withdraw his preservation fund before retirement?
Tax payable on his lump sum of R1 100 000 at retirement (as per retirement lump sum tax table on page 18):
R130 500 + R18 000 (36% of R50 000)
= R148 500 tax payable
Jabu has therefore paid R247 500 (R396 000 – R148 500) more tax on retirement because of his early withdrawals. Remember that Jabu would have also paid tax on these withdrawals at the time.
* Lump sum in this article refers to any cash amount that a retirement fund member is allowed to take from their retirement fund instead of purchasing an annuity