Murmurings around prescribed assets in South African retirement funds have caused a wave of resistance and hesitation among investors to further invest in retirement funds. Prescribed assets could make it a requirement to buy government or state-owned enterprise (SOE) debt, or to invest in pre-determined developmental projects such as schools, state-hospitals and infrastructure.
Since the introduction of Section 7C (deemed interest income) on the loan accounts to trusts, retirement saving vehicles have remained among the very few effective estate planning tools.
Alternative estate planning tools take many years to implement cost and tax efficiently. It is, therefore, dangerous to exit your retirement fund strategy (one of the cornerstones of an estate plan), that you have built up over many years.
Deciding whether South Africans should contribute further to retirement funds, is a multi-dimensional decision that impacts holistically on the investors’ wealth, taxability, estate plan and asset protection structure.
Withdrawing from your retirement funds/stopping contributions
Investment decisions like these are sometimes seen as having a small impact on your wealth as many implications are hidden beneath the surface. The truth is that these decisions could have massive ramification to some over the long-term. The impact on the withdrawal of retirement funds or opportunity cost (of not contributing), can be quantified as follows:
- Pre-and-Post retirement lump sum withdrawals taxes;
a) Pre-retirement withdrawal for amounts > R25 000 (previous withdrawals will be aggregated) are taxed at a minimum rate of 18%. This tax rate progresses up to a maximum rate of 36%. A lump-sum withdrawal of say R5 million would thus experience a 32.94% tax penalty (±R1.65m) on a pre-retirement withdrawal.
b) Post-retirement withdrawals amounts > R500 000 (previous withdrawals will be aggregated) are taxed at a minimum rate of 18%. This tax rate progresses up to a maximum rate of 36%. Post-retirement withdrawals of R5m will thus result in a 31.05% tax penalty (±R1.55m) on a post-retirement withdrawal.
- Investors that do not further contribute towards retirement annuities/pension funds will forfeit on a tax deduction [27.5% of the greatest of taxable income/remuneration (up to a maximum of R350 000 per tax year)]. Assuming a maximum marginal tax rate of 45%, an investor will forfeit a maximum of R157 500 per year in tax refunds (R350 000 x 45%).
- Investment capital outside official retirement fund vehicles forms part of an investor’s dutiable estate (estate duty of 20% for estates < R30 million and 25% for estates > R30 million). Discretionary capital without a nominated beneficiary appointment is also subject to executor’s fees of up to 3.5%+VAT.
- Some offshore investments (e.g. equity-linked/physical property) investments will further incur Capital Gains Tax at death (max 18% gains when over R300 000 exemption at death);
- Some offshore investments are no longer free from (e.g. market-linked equity/bond investments) dividend income-, interest income and even situs taxes.
More investment considerations before externalising your retirement assets:
- One of the biggest risk-management-benefits of retirement funds is the protection that these investments enjoy under our Pension funds Act against creditors’ claims, specifically to business owners/farmers.
- Risks of moving investment capital out of an “out of favour” JSE equity market, for reinvestment into e.g. a “most favoured” US equity market.
- Risks of moving investment capital out of a weak South African rand and buying into a strong US dollar, for example.
Two recent purchasing power index comparisons (Coca-Cola and Big Mac Indices) both indicated the rand is substantially undervalued. Even if you consider them as a bit optimistic, it is still necessary to consider the longer-term average exchange rate of the rand. A country’s currency is, in essence, the perceived/illustrative price tag of a country (in comparison to other countries). Currencies are therefore undervalued during times of extreme uncertainty / economic pressures. SA with the most liquid capital (equity and bond) markets in Africa can experience extreme rand volatility and requires caution during times of extreme pessimism.
Retirement funds vs. direct offshore investment
Retirement fund investment requires a patient, long-term commitment from investors. These investments grow at a slower pace than say a 100% equity portfolio but grow at a more appropriate level of risk to many investors (through various economic cycles).
Direct offshore investments are not risk-free and as stable as many investors are hoping. Returns from offshore balanced “high-equity” funds over the last 5 years were double than that of local balanced funds to this point. Once considering the punitive tax results mentioned above, the negatives quickly add up (add percentages from lump-sum withdrawal penalty, estate duty, executor’s fees and additional taxes). Last but not least, investors also have to consider current market price disparity (local record low vs. offshore record high indices) and long-term currency reversion.
Deciding to withdraw retirement capital causes clear and substantial changes to your wealth tax structure. Always follow a holistic, diversified approach to investing by optimising your taxes and avoid irreversible decisions (specifically the ones that are driven by emotions).
South Africa may be at a point of maximum pessimism and the deal you are getting by selling out of your retirement funds is not a great one. Retirement fund returns are clearly just the first dimension of such decision.
Racing is more than just acceleration, it is also about brakes, handling and safety features to keep the driver alive. So if you want to “race” assets offshore, retirement funds are not the obvious first place to look.