Retirement lump sum: how much to take?
12 November 2012
Posted by: SAIT Technical
By Bruce Cameron (Tax Talk) http://www.persfin.co.za/
Executive summary (SAIT Technical)
Upon retirement, a member of a pension fund or retirement annuity fund has choices on how much to take as a cash lump sum. Up to one-third may be taken as a lump sum. The question arises how much to take as a lump sum? The first R315 000 is tax-free. Several factors will impact this decision. The larger your lump sum, the smaller your annuity will be. This will affect your marginal tax rate in future years. Bruce Cameron also discusses some of the tax incentives National Treasury has proposed for savings.
One of the important questions you must answer at retirement is how much you should take as a cash lump sum from your retirement savings.
If you belong to a provident fund, you have no choice: you receive all your retirement savings as a cash lump sum, which are subject to the lump-sum tax rates (see table, link below).
But if you retire from a pension fund or a retirement annuity (RA) fund, you have choices. You are allowed to commute up to one-third of your retirement savings to cash, but, again, subject to the lump-sum tax rates.
There are also considerations if you are a member of a defined-benefit fund, where the fund provides a pension and the pensionable income stops on the last to die of the fund member or his or her spouse. In this case, you may want to control more of your capital.
However, in deciding how much to take as a lump sum, a member of a defined-benefit fund must also take into account all the issues that affect a member of a defined-contribution fund.
Currently, it is a no-brainer that you should take the tax-free amount of R315 000.
As for taking more as a lump sum, the decision would seem to be based on your marginal rate of taxation. If you are on the top marginal rate of 40 percent, you should also take the other amounts and reinvest the money.
But it is not quite this straightforward. The major reason is deferred tax.
In simple terms, it works like this: say you have R4 million in a tax-incentivised pension fund when you retire and you buy a pension of R17 000 a month (R204 000 a year). Assuming this is your only income, it would put you on a marginal tax rate of 25 percent.
So the knee-jerk assumption is to take the first R315 000 and the next R315 000, because you pay tax at a rate of only 18 percent on the second R315 000 – a saving of seven percentage points.
But say you have R10 million in a tax-incentivised pension fund when you retire and you want a pension of R42 000 a month (R504 000) a year. Assuming this is your only income, it will put you on a marginal tax rate of 38 percent. In this case, it may appear best to take R3.3 million as a cash lump sum, because you will pay no tax on the first R315 000, and save 20 percentage points on the second R315 000, 11 percentage points on the next R315 000 and two percentage points on the rest.
But there is a lot more to consider.
The immediate problem with the above calculations is that they do not take into account the progressive rates of marginal income tax. For example, the first R160 000 you earn in a year is tax-free and the next R90 000 is taxed at 28 percent, so you are not saving as much as you might think.
The other tax issues are:
* The primary rebate for all taxpayers (R11 440 in the 2012/13 tax year), while anyone aged 65 and older receives a secondary rebate (R6 390), and those 75 and older receive a third rebate (R2 130).
* Deferred tax. When you retire and draw a pension bought with the proceeds of a pension or an RA fund, you are taxed at your marginal rate of income tax when you receive your pension.
You are taxed on both the percentage of your pension that comes from the capital you saved and the ongoing investment returns. The reason your capital is taxed when you receive it as a pension is that you did not pay tax on it when you saved the money. This enabled you to earn investment returns, again tax-free, on money that would otherwise have gone in tax.
When you pay tax on your pension only when you receive the money, the balance of your capital is earning returns. As long as you do not withdraw the money, you will receive tax-free returns on it.
* Retirement fund tax incentives. The investment returns on retirement fund savings are not subject to income tax, capital gains tax or dividend withholding tax of 15 percent if they are held in a retirement fund or pension you have been obliged to purchase after retirement – a compulsory purchase annuity.
In other words, you are again earning money on money you would otherwise have paid in tax if you had taken amounts in addition to the R315 000 as a lump sum at retirement and then invested the money.
Youri Dolya, best practice leader at Alexander Forbes retail, says when deciding on the optimal cash lump sum you should take at retirement, you should also consider the following factors:
* Product restrictions. For example, you may want to invest money outside of a guaranteed annuity.
* Any retirement fund withdrawals or commutations you made from a retirement fund, including an RA fund, after March 2009, on which you have already received tax exemptions based on the lump sum tables.
* Any previously disallowed contributions, which will be added to the tax-free portion.
* Medical scheme contributions, which are deductible from your taxable income.
* Your level of debt: how much of the lump sum you will be able to reinvest once you have settled your debts.
Dolya says the amount you should withdraw will depend on your individual circumstances.
Alexander Forbes has developed a calculator that provides a general indication, but you cannot expect it to provide the perfect answer, because a number of assumptions have to be made about variables such as investment returns.
You are well advised to seek the assistance of a financial adviser who can do the calculations for you if you want to withdraw more than R315 000 as a lump sum.
TAXATION OF RETIREMENT LUMP SUMS IN THE FUTURE
Taxation is seldom static, and in recent years this uncertainty has applied particularly to the taxation of retirement savings.
There have been changes in the way lump-sum withdrawals from retirement funds are taxed prior to retirement and at retirement. Next year, the contributions to a retirement fund that you may deduct from taxable income will also change.
And also on the list of proposed changes to tax laws are:
* A proposal that you should be allowed to get the tax-free advantage from the lump sum taxation table whether you actually take the money as a lump sum or use it to purchase a pension. Currently, you are taxed at your marginal income tax rate on the full income you receive as a pension. This will mean that part of your income flow could be exempt from tax.
* A proposal that the current exemption on a portion of the interest you earn on investments be scrapped. Instead, National Treasury wants to introduce a system of special savings accounts that would not be subject to tax. The maximum amount you would be allowed to invest would be R500 000.
If these changes come about, the lump-sum decision will get a lot more complex – you will need to take various factors into account in making a decision on how much to take from your retirement savings as a lump sum. These include:
* The effect of not paying tax on interest, dividends and capital gains on the capital in your residual pension savings until the capital is withdrawn. This deferment of tax will be for the lifetime of the pension.
* If you have no other savings, whether it will be best to use a lump-sum withdrawal up to R500 000 from your retirement savings at retirement to take advantage of the proposed tax-free special savings accounts.
* The effect of inflation, as it will reduce future values, particularly of the R500 000 if it is not adjusted for inflation.
However, the general rule when it comes to tax is that you must make decisions on the basis of the current taxation regime and not what may or may not happen in the future.