It's not always easy to see the tax implications of financial decisions you make. And more so now, that South Africa's tax legislation has changed significantly in the last two years. Personal Finance has enlisted the help of Deborah Tickle, a tax partner at KPMG, to explain common tax problems. This week, she deals with a reader's question about moving his pension fund money.
A reader recently wrote to Personal Finance asking for confirmation that his decision to move from his company's pension fund to its provident fund was the right one.
His decision was made on the basis that the pension fund was defined benefit (the benefits to which he is entitled are determined regardless of the success of the fund), whereas the provident fund was defined contribution (the contributions are pre-determined, but the benefit is directly related to the success of the fund).
Based on the recent good performances of defined contribution funds, our reader felt that he could fare better in the provident fund.
However, a number of factors must be considered before making such a decision. Firstly, there are the tax consequences of moving from a pension fund to a provident fund.
Sometimes, tax laws have seemingly odd rules, and so it may seem here. Whereas you can transfer freely from a provident fund to another provident fund, a pension fund or a retirement annuity fund (RAF) with no tax consequences, it is only if you move from a pension fund to another pension fund or to an RAF, that you won't suffer any tax consequences.
A transfer from an RAF also has limited tax-free movement, in that the lump-sum benefit can be transferred to another RAF or used to purchase an assurance policy with similar benefits to the RAF.
But what would happen if our reader transferred from a pension to a provident fund?
The reader's lump-sum benefit will be treated as having been withdrawn from the pension fund and, to the extent that it exceeds R1 800 plus the amount of any contributions he made that were not allowed as a deduction for tax purposes - provided these do not exceed the lump sum - it will be subject to tax. The rate of tax applied to this amount is effectively the higher of our reader's average tax rate for the current and last year.
Thus the amount transferred to our reader's new provident fund for the purposes of investment on a defined contribution basis is somewhat reduced. This could have devastating results if the reader is not far from retirement age.
Let's say our reader is 53 years old, has been a member of the pension fund for 25 years, and plans to retire at 55. He has been advised that the amount of the current lump-sum benefit for his account in the pension fund is R140 000. The reader's average tax rate last year was 23 percent and for the current year it will be 24 percent. He has also been advised that when he retires, it is anticipated that his lump-sum benefit will be R160 000.
If he moves to the provident fund now, the amount available to move across will be R140 000 less the tax thereon. The tax is calculated by taking R140 000, less R1 800, multiplied by 24 percent - that is, R33 168.
Thus the amount which is available to move across will be R106 832. We will assume that when our reader retires this will amount to R142 000 (that is, assuming the fund achieves growth of about 15 percent a year).
The difference
What would be our reader's position on retirement?
If he had remained in the pension fund, due to the length of time he has been a member of the fund R120 000 of the lump sum of R160 000 would have been tax-free.
Thus, he would be taxed on R40 000 at his relevant average rate of tax. Assuming this is still 24 percent, his tax would amount to R9 600, and he would be left with R150 400, having paid a total amount of tax of R9 600.
On retiring from the provident fund, our reader will also receive R120 000 tax free, and be taxed at a rate of 24 percent on R22 000 - R5 280. He will be left with R136 720, having paid a total amount of tax of R38 388!
From a cash-flow point of view, consider that the contributions to a provident fund are not tax-deductible on payment, whereas the contributions to a pension fund are.
So, your cash flow will be affected unless your employer is making the full contribution. (The non-deductible contributions are taken into account when the tax-free portion of your lump sum is determined).
There are definite benefits to a defined contribution provident fund, but you need to be fully aware of the tax consequences of a move to such a fund, and measure those against the benefits before you decide to switch.