Should you cash in a preservation fund to clear your home loan?

Question

I have a preservation fund worth R1.3-million. The growth in that fund has not been particularly good (about 9% a year over the past five years).

I’m thinking of cashing it in and using the proceeds to clear my home loan of R1-million, where I am paying interest of 10.5%. I have 20 years to go to retirement.

Would you recommend this?

Answer

There are a few 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 implications

You need to be aware of these taxes:

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 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 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 R1.3-million from your preservation fund, it will trigger tax according to the table below.

So, on a withdrawal of R1.3-million you will pay tax of R315,000 and get out R985,000.

If you left the money 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 than you are currently getting, 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.

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 past five years. This is significantly higher than the 10.5% interest you’re paying on your bond and the 9% return you’re 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.

Given your long timeframe 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. DM

This story first appeared in our weekly DM168 newspaper, available countrywide for R35.