Question

I have a preservation fund worth R1.3 million. The growth in that fund has not been particularly good (around 9% a year over the past 5 years).  I’m thinking of cashing it in and using the proceeds  to clear my home loan of R1million where I am paying interest of 10.5%.  I have 20 years to go to retirement.

Would you recommend this?

Answer

There are a couple of factors that you need to consider when making this decision.   These would include tax and the possible returns you could get  from your preservation fund

Tax

There are a couple of taxes that you need to be aware of

• Tax inside the preservation fund

The R1.3 million inside your preservation fund is growing in a tax friendly environment where no capital gains tax,  dividends tax or tax on interest is being applied. This is certainly a great environment to build up wealth if you choose the correct investment portfolio.

• Tax on the new investment

If you use the proceeds of your preservation fund to clear your bond and then use the money that you would have put into the bond each month to build up a new investment, this investment will be subject to tax on interest,  dividends and capital gains.

On the other hand, when you eventually start drawing an income from this investment, the tax will be much lower than if it came from a retirement fund.  This is because the withdrawals from this investment are taxed as capital gains, not as income, which is how annuity payments from a retirement fund are taxed

• Withdrawal tax

If you withdraw your funds from the preservation fund you’re going to be hit with a  retirement fund withdrawal tax.  If you withdrew the R1.3m from your preservation fund, it would trigger tax according to this table

So, on a withdrawal of R1.3 million you will pay tax of R315,000 and get out R985,000.  You will therefore  lose about 25% of your preservation fund immediately.

If you left the money where in the preservation fund,  the full R1.3 million would continue growing tax-free inside the fund.  By withdrawing it, you’re effectively investing only R985,000 (the after-tax amount) into your bond, saving interest at 10.5%, which is the rate you currently pay on the bond.

In other words, to get a return that is only 1.5% higher, you would first have to pay R315,000 upfront in tax.

Before deciding if that’s worth it, we need to check if we can get a better return on your preservation fund.

Potential returns you could get from your preservation fund

Preservation funds must comply with Regulation 28, which sets limits on how much can be invested in equities, offshore assets, and other categories. Even with these limits, you still have room to choose a portfolio that matches your long-term goals.

Because you have 20 years before retirement, you can afford to take a more growth-oriented approach. For example, the Regulation 28-compliant portfolio I frequently recommend has delivered an average return of 17% per year over the last five years. This is significantly higher than:

• the 10.5% interest you’re paying on your bond, and
• the 9% return you are currently earning.

Given this, it would be wise to review your portfolio choice within the preservation fund before considering a drastic move like cashing it in and absorbing a large tax penalty.  A stronger, growth-focused portfolio could potentially give you substantially better long-term returns without the upfront loss of R315,000 in withdrawal tax.

Cashing in your preservation fund now would cost you a large amount in withdrawal tax and leave you with significantly less money working for your future. Given your long time frame and the potential to earn far better returns inside a correctly structured Regulation 28 portfolio, it makes more sense to review and improve your investment strategy within the preservation fund rather than withdrawing it to settle your bond. This approach keeps your full R1.3 million growing tax-free and avoids an unnecessary upfront tax loss.