2020-09-21 Moneyweb Readers Questions

I am 58 years old and in good health. I have a provident fund of close to R6.6 million. I am planning to leave my current job and want to buy a well-established guest house in Graskop for R3 million using money from my provident fund. The guest house has had an average turnover of R900 000 per year over last three years.

I know I have to pay tax when I cash in my provident fund, so this means I will need to cash in more than the R3 million. Is it a good thing to use most of your provident fund as capital in a new business? It will at least give me steady income over the next 15 to 20 years before I finally retire.

There are several factors which need to be explored in detail in order to help you with an analysis of your options and the potential risks associated with those options. Due to the scope of this response I would recommend that you explore this in further detail with a professional financial adviser.

Assumed tax on withdrawal?

In order to try and quantify the gross withdrawal amount that is required to generate the R3 000 000, I have used the Allan Gray withdrawal tax calculator. I made the assumption that you haven’t taken any previous withdrawals or benefits.

In order to generate R3 000 000 net of tax, you will need to withdrawal approximately R4 500 000 which equates to 68% of your provident fund.

AllanGray Withdrawal Page

Investment time frame

Under the guest house scenario, your stated investment time frame before retiring is 15-20 years, but be aware that this is also “health dependent”. This is potentially a long period of time. I assume that your current employment provides for a retirement age of 65, being in 7 years’ time.

On the one hand, if you leave your provident fund to grow and compound over the next 15-20 years, depending on your risk profile and underlying investments, it could achieve a pleasing return over the period. Once you retire in perhaps 7 years’ time you can generate an income from the provident fund. This assumes that you continue to earn an income from your current job until then.

On the other hand, if we assume that you are able to buy the well-established guesthouse and run a successful business over the next 15-20 years whilst leaving your remaining R2 100 000 to compound in a provident preservation fund over that period, it may be a worthwhile investment.

Quantifying the business risk

The largest unknown factor in the equation is the business risk that is associated with running the guesthouse.

Points to consider

  • Do you feel comfortable that you are able to run a successful guesthouse business? Do you have any experience in this industry or in business generally?
  • Will the business require any addition capital over the next several years? Additional capital requirements may be an unforeseen burden on your cash-flow.
  • Of the R3 000 000 what percentage of the sale price consists of physical assets such as the guesthouse itself (assets which you could sell in the event that the business is unsuccessful) and what percentage is based on the profitability of the business?
  • How flexible will your overheads be should you need to run the business as lean as possible for a period of time?
  • Do you have a business plan to increase turnover?

I recommend that you try and quantify the business risks to the extent possible. This can be achieved through a business plan and cash-flow projections based on several scenarios e.g. best case scenario, worst case scenario, realistic scenario. Bear in mind that its unlikely that you can afford to take a big knock on this because it represents the majority of your pension, and you do not have time on your side to build it up again.

Alternative considerations

You may consider the possibility of raising a bond for a portion of the sale price. Interest rates are relatively low. Raising a bond comes with its own set of risks particularly if the business doesn’t have a consistent and reliable cash-flow to provide for overheads as well as the bond repayments and a living wage.

It is worth exploring this option to see what the financial implications are should you raise a bond against the property to fund a portion of the sale price.

  • What interest rate would you be able to secure?
  • What would the term be?
  • Are the monthly repayments feasible given your analysis of the business plan and cash-flow predictions?

Summary

Given your age, it is important to recognize that should you venture into a business with the proceeds from the withdrawal of the majority of your pension fund as your start-up capital and the business is unsuccessful, you could find yourself in very concerning financial position.

If you are comfortable with the business risks and the sale price, then it may be worth considering raising a small bond on a portion of the sale price which must be built into your cash flow.

As a contractor (Tax Code: 3616 on the SARS deductions codes) mid 30s single male.

Each year I receive a SARS refund; this is primarily driven by retirement annuity (RA) contributions and other items that I can claim based on my line of work.

For illustrative purposes, let’s assume an annual pre-tax income of R1 million and that, based on TAXTIM calculators, I paid R307,813.00 in PAYE taxes and received a refund of R50 000. What is the best way to spend this money?

My options:

  1. Reinvest into an RA;
  2. Settle credit card debt which attracts interest of 15% and has an outstanding balance of R44 000 (currently serviced at R2 500 per month);
  3. Invest the money in a tax-free unit trust (my current financial plan does not have provision for withdrawals);
  4. Use the money as a deposit for a money market account and top up to make the R100 000 minimum balance required. (Useful for emergencies)

Let’s further assume that I have a home loan of R1 million, with an outstanding balance of R650 000, tax rate of 6.75%. For the bond, let’s assume I pay the bond and a top-up which means I pay a total of R10 000 p/m. Let’s also assume that there is vehicle finance with a balance of R350 000 at 12.75% fixed, with a term of 36 months remaining.

How would you suggest this tax refund is utilized?

I have tried to cover all the necessary assumptions to paint the picture. Looking forward to your answers and guidance as there are a number of divergent opinions on saving vs settling debt.

Based on your scenario your question relates to reducing debt, investing the refund or contributing towards an emergency fund.

All three options could be considered as well thought out ways to utilise your tax refund. It is important to note that there is no one right or wrong answer to your question as it relates to what may be most appropriate for you in your financial circumstances and your personality type.

Reducing debt

Interest rates on credit card debt can be relatively high. It is typically significantly higher than one pays as interest on a bond. It therefore stands to reason that it may be more beneficial to pay off credit card debt over additional bond repayments.

The behavioral finance aspect of paying off credit card debt rather than paying off one’s bond or investing the money, is that it may only be beneficial if the credit card debt is subsequently kept at low levels. Once paying off credit card debt, the temptation is to once again re-utilise that credit facility again in the future.

This is an important principle that consumers need to be mindful of. If one reduces credit card debt levels and therefore saves on interest repayments, one needs to be diligent enough to keep credit card debt to a minimum thereafter. This is best achieved by reducing your credit card limit with the bank, which forces the appropriate behaviour.

Reinvesting the refund

Reinvesting the refund is certainly an option. This can be done through additional retirement annuity contributions or through a tax-free savings account.

The consideration between reinvesting the refund and paying off high interest debt from a pure return perspective is around the possible return achieved through an investment compared to what you pay as after-tax money towards both the interest on the debt and the capital.

There has to be a balance between saving and repaying debt. This ideally requires modest levels of affordable debt whereby one can simultaneously save and repay debt. Bond repayment is an automatic compulsory monthly repayment to which you allocate part of your after-tax income. It is structured, has a long term and favourable interest rates, and you would not typically dream of defaulting on this repayment. Credit card debit on the other hand typically attracts a minimal monthly repayment, is unstructured and is expensive. It should be prioritised for settlement before bond repayment.

The benefits of a tax-free savings account make it an ideal investment vehicle to use up to the maximum annual contribution of R36 000. Investors should ideally max out their annual contributions each year. This is something to consider going forward.

Contributing towards an emergency fund

It is important to have an emergency fund should you find yourself in a position where you have a relatively large unexpected expense. It is important to have between 3-6 months’ worth of income in an emergency fund.

“Use the money as a deposit for a money market account and top up to make the R100 000 minimum balance required. (Useful for emergencies)”

Investment platforms such as Allan Gray allow for investors to open investment directly through the platform provider. Their minimums are significantly lower than R100 000 and they offer both money market funds and income funds which can be used in the underlying investment. R100 000 seems quite high as a minimum for a money market account.

Additional considerations.

You may consider re-bonding your home (if you have the capacity) in order to pay off your vehicle finance which has a fixed interest rate of “12.75%”. This will effectively reduce the interest that you are paying on your vehicle as the interest will be charged according to the interest rate which is applied to your bond at “6.75%”.

Summary

You should consider using the tax repayment to settle your credit card debt. This stands to reason as the most prudent thing.

The R2500 you are currently using to pay off the credit card should then be re-directed to a monthly debit order investment. This will build up fairly quickly to become a meaningful sum of money and you will get the benefit of Rand cost averaging (investing over time) versus investing a lump sum. Investors need to start somewhere when it comes to discretionary saving.

A tax-free investment is a great investment vehicle to use when building up either an emergency fund or for the purpose of pure wealth building.

You should consider restructuring your vehicle finance with that of your bond in order to reduce the interest that you are paying.

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