First appeared in Estate Living
It’s not uncommon to change jobs every few years and at the same time decide to cash out your Provident Fund. It seems like a great way to access some “quick cash”, but is it really worth it?
The tax implications of cashing in your Provident Fund
Tax discussions can be so boring and when faced with cashing in your Provident Fund why wouldn’t you? Seems like a great way to get that much needed money to pay off debt, take a quick holiday or to invest. Many people have trust issues when it comes to their employers choice of fund administrator and would much rather have more control over their investments. This is understandable but it’s certainly best to chat to your Financial Advisor before jumping ship.
Calculating the tax
It’s pretty simple to calculate the tax you’ll pay if you decide to withdraw your money (or portion thereof). SARS provides the “Retirement Lumpsum Benefit” tax table which currently looks like this:
- First R25,000 is tax-free.
- R25, 001 – R660, 000 18% of taxable income exceeding R25, 000
- R660, 001 – R990, 000 R114, 300 + 27% of taxable income exceeding R660, 000
- Exceeding R990, 000 R203, 400 + 36% of taxable income exceeding R990, 000
Starting with a simple example of Thabo withdrawing R300,000 from his provident fund, the tax due would be 18% of R275,000 which is R49,500 (effectively 16.5% of the total amount).
As another example, Melissa is withdrawing R1,250,000 and the tax on this would be R297,000 which is an effective rate of close to 24%.
Clearly the larger the withdrawal amount, the larger the effective tax rate is and the more carefully one should consider withdrawing the funds.
Jumping between jobs
The younger you are the more likely you’ll be changing jobs often and it’s not uncommon for a 20-something year old to switch jobs 10 or more times in their career. And it’s not just limited to changing companies, many will have a complete change of career and essentially “reinvent” themselves.
When faced with the option of a cash lumpsum now versus preserving your fund for the future, the here-and-now usually wins. It’s hard to see the future benefit when you’ve got commitments and responsibilities right now.
I’ve tried to keep the following example as simple as possible. Lerato is 25 years old and contributes R5,000 a month towards her retirement. We’ll assume a 5% increase in contribution each year and we’ll put in a small growth rate of 6% per annum on the investment.
This table shows how tax on withdrawal erodes your investment as you would either need to invest at a better growth rate than you currently have (and possibly with reduced fees) or you would need to invest for longer.
This becomes far more evident when making withdrawals often throughout your career but it’s unfortunately hard to depict as there are so many variables and options.
Tax implications and considerations
The truth of the matter is that one can never get away from paying taxes, and whether you bite the bullet now to free up your investments or wait until retirement, you’ll be paying tax somewhere. Persevering your funds by either transferring them to your new employers provident fund or to a preservation fund will potentially reduce your overall tax liability. It also prevents you from wasting it on lifestyle choices which can be very tempting.
Exiting early (and often) with low effective tax rates could be quite compelling if you consider that you might have otherwise bought an annuity with this money and been subject to marginal income tax rates on this money later in life. Then again, chances are your income would be lower, and you might likely only suffer income tax at these sorts of effective rates in any event.
Another way to look at exiting at these lower tax levels, is that it could be a great way to access after-tax money that can be invested for the long-term, giving rise to capital gains, which are taxed at much lower rates than an annuity.
Things change though, when you consider withdrawal amounts in the millions as the effective tax rate can jump as high as 33%. Again, this allows you to prevent being subject to paying marginal rates on an annuity when you reach retirement on this money, but does mean crystalizing a material tax burden now. The benefits of tax deferred investing for the long-term should then definitely be considered.
What’s the money for?
All these examples simply illustrate the tax implications of withdrawing from a provident fund or provident preservation fund. It doesn’t deal with whether you should or shouldn’t be withdrawing in the first place.
If you’re planning on investing the full amount then you’re probably headed in the right direction. If however the money is simply to pay off debt, improve your lifestyle or renovate the home then you should really consider the future impact.
If you’re going to withdraw cash from your provident fund when you leave your job, it stings less if the balance of that account isn’t too large. The bigger the balance gets, the more tax you’ll pay. If you think there’s a better investment opportunity for the money (and it had better be pretty good), then seek sound financial advice and put the money to work.
The effects of compounding growth are often forgotten but the reality is that it is very challenging to “catch up” on your investments.