In this article on the TMA/Personal Finance `Truth about Retirement` seminars, Esann de Kock reports on the views of Andrew Bradley, managing director of Capital Alliance Management Company, concerning investing in retirement annuities versus preservation funds.
It is imperative that you assess the tax as well as the investment implications before you take a decision on whether to put your retirement money in a retirement annuity or a preservation fund.
Opting for a preservation fund offers a variety of benefits.
Andrew Bradley, managing director of Capital Alliance Management Company, says prior to these funds, the most commonly-used vehicle was a retirement annuity fund.
But, since the advent of preservation funds, retirement annuities have been sparingly used as a parking place for retirement funds.
Bradley says in most instances the better approach is to use a preservation fund.
However, sometimes the use of a retirement annuity fund instead of a preservation fund can be beneficial.
How tax should influence your decision
It is important that you assess the full range of implications when you withdraw from a pension fund or provident fund.
Bradley says a key factor which makes a retirement annuity an alternative to a preservation fund is the tax formula, at retirement, on the payout.
In terms of current tax legislation, two different formulae apply to your payout when you retire. They are commonly referred to as Formula A and Formula B.
If you retire from a retirement annuity fund, only Formula B applies. If you retire from a preservation fund, you have to comply with both Formula A and B.
Formula A is the total number of years you have been a member of a fund divided by 10, multiplied by your highest average salary over any five years. The highest average annual salary is limited to a maximum of R60 000 a year.
Therefore, if you have been with the preservation fund for less than 20 years, your payout will be less than the R120 000 you are allowed tax free from a retirement annuity.
Bradley says it is only once you have determined this value that you go on to Formula B, which provides for a tax-free benefit which is the greater of R120 000, or R4 500 times the number of years of membership of the fund.
He says you should note that, unless you have been in a preservation fund for 20 years or more, your tax-free payout will be less than R120 000. But, where you have been in a retirement annuity for less than 20 years, your tax-free payout will still be at least R120 000.
Bradley says the examples should show you that where a retirement fund member has withdrawn from a pension fund at age 55, plans to retire at age 60, brings with him five years' service on his current pension fund with a payout of R600 000 anticipated in five years time at an average tax rate of 35 percent, he is going to be in a better position having used a retirement annuity rather than a preservation fund.
The reason for this is that, of the one-third payout being R200000 in a retirement annuity, the first R120000 would be tax-free. The balance of R80000 would be taxed at a rate of 35 percent, leaving you with a net benefit of R172000.
If a preservation fund was used, your tax-free benefit would have been a mere R60000.
The reason for this is that with the five years' membership in the preservation fund as well as the five years' membership in the pension fund, your total years of service would have been 10 years.
In terms of Formula A, the maximum benefit available to the member would have been R60 000 tax-free and would have resulted in an additional tax burden.
However, Bradley says in situations where you have been a member of the pension fund and preservation fund for more than 20 years and particularly for more than 27 years, then in terms of the formula (R4 500 multiplied by the number of years), you will benefit by being in the preservation fund.
This is because, in a preservation fund, you conserve your years of membership, whereas this is not the case when you transfer from a pension fund to a retirement annuity.
So, in the second example, where the individual had 20 years' service in addition to another 25 years' membership of the fund, his total membership would have been 45 years, therefore leaving the full R200 000 tax-free.