Question:
I resigned effective 31 January 2009 at age 42 from a law firm where I was a director. I have instructed the Legal Provident Fund to transfer my retirement benefit into a Preservation Fund. I was informed yesterday that, notwithstanding my resignation being effective from the end of January, the transfer into the Preservation Fund would probably only take place later this week. I intend withdrawing the full benefit on 1 April 2009.

What will my tax liability be assuming the benefit paid out is in the region of R820 000?

Answer:
Most of us have been there and I’m sure many of us will revisit this situation a few more times in our lives. Besides the many practical and even emotional decisions that need answering, the financial decisions demand a strong framework in order to best tackle this potential money minefield.

The often told truth about money is that the decisions we make today will impact our financial well-being in the future. But whether the impact is positive or negative depends entirely on your decisions.

I cannot claim to have a firm grasp of your current financial circumstances other than the information provided and therefore am unable to advise whether your choice is the correct one or not. However, what I can do is 'enact' your scenario and highlight the potential tax considerations and ponder the long-term impact.

Before tackling the issues at hand, I noticed that you intend withdrawing the full amount once it is transferred into a preservation fund. Considering that the option of withdrawing directly from the provident fund should have been available to you, one would need to question the reason for incurring the costs of transferring first. That aside, let's have a closer look at your scenario.

Firstly, when considering your tax liability, we consider the recently promulgated Revenue Laws Amendment Act to ascertain how SARS will treat your withdrawal. As of 1 March 2009 tax on withdrawals changed substantially and was brought in line with the concept of a tax table. The first change was that the tax-free amount increased from R1800 to R22 500. Then all amounts exceeding this tax-free amount are taxed according to a tax table that stipulates the first R300 000 will be taxed at 18 percent, the next R300 000 at 27 percent and the next R300 000 and above at 36 percent.

So, what does that mean for you? Well, after deducting R22 500 (tax-free amount) you will have a taxable portion of R797 500. Using the table guidelines above, this will result in a potential tax liability of R206 100. The reason I say 'potential' is because there are other factors that impact on this such as previous withdrawals as well previously disallowed contributions that are not mentioned.

But the taxation considerations do not end there. What the new laws have incorporated is that all withdrawals will impact negatively on the taxation of your retirement benefits upon retirement. Firstly, the tax-free amount at retirement of R300 000 is reduced by all previous withdrawals (in your case R820 000), meaning that you will have lost that benefit. Secondly, all previous withdrawals will be added to the lump sum commutation selected and taxed on a cumulative basis according to the same tax table as mentioned above. So, in essence, not only will you have sacrificed your retirement tax-free amount, but all benefits will be taxed at a higher effective rate of tax.

The taxation discussion is well and good, but what are some of the practical considerations associated with this scenario? Well, for the benefit of other readers, let’s consider withdrawal impacts on various age groups to gauge where you may fit in.

To begin with, let’s assume a retirement age of 65 and ignore taxation. Although the figures below depend on a number of assumptions that could be influenced, the core principles remain the same. If you were 25 years old, this would require you to invest 15 percent of your income to receive 75 percent of your final income in retirement (also known as replacement ratio). If you were to withdraw at 35 and try to start over, then one of two things would happen: either you would need to invest 23 percent of your income to get the same result or settle for a 50 percent replacement ratio. At 45 you would either need to invest 39 percent of your income or settle for a 30 percent replacement ratio. Going further, the figures become ludicrous and daunting. One may ask how there could possibly be such a significant impact and the answer is quite simple: compound interest. We have all heard of its power and the startling results it can deliver if harnessed early, but cut it short (by withdrawing) and be prepared to relinquish the benefits of this 'secret weapon'.

So, when considering your options upon resignation (or even retrenchment) be sure to look further than just the immediate tax consequences. Trevor Manuel (and the rest of SARS) has been clear in his intention of trying to encourage preservation of benefits and have done this by increasing the tax burden of those who choose to withdraw. Furthermore, the longer term practical consequences of withdrawing your benefits may be the difference between achieving financial freedom or not — do not underestimate the power of compounding interest and be sure to treat it with care!

The above information is designed to give you an idea of what you can potentially expect from a tax liability point of view and explore likely practical implications. One should always seek the professional opinion of a Certified Financial Planner when trying to ascertain the exact implications of your specific scenario.

All the best.

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