For many years, individuals with earned income liable to the higher rate of tax have made contributions to an appropriate pension vehicle. By doing this, they were (a) saving for their retirement and (b) taking advantage of significant tax reliefs in place in respect of personal pension contributions.
However, due to recent developments, such as cutting the earnings limit to €150,000 from €254,000 and the introduction of a €2 million cap on pension funds, individuals have reservations as to the rationale behind making a personal pension contribution. Some individuals are considering alternative wealth accumulation vehicles, such as investment bonds, fixed long term deposit accounts or property investments. In this article we will consider if it still makes sense to make a personal pension contribution.
Developments in Irish Pension Legislation
Recent developments in Irish Pensions have largely been negative. There has been a reduction in pension tax incentives both at the funding and the retirement stage. The key developments are as follows:
- The earnings limit used to calculate a tax efficient individual contribution has been reduced from €254,000 to €115,000 in respect of the age related maximum contributions
- The maximum lifetime tax free lump sum limit has been reduced from €1.35 million in 2010 to €200,000
- The maximum lifetime pension fund has been reduced from €5.4 million in 2010 to €2 million.
- Distributions from an Approved Retirement Fund are liable to the USC as follows:
|To age 66||40%||4%||8%||52%|
Do pension contributions still make sense?
While recent developments have clearly reduced the tax efficiency of pension contributions, there are still some significant positives:
- Income tax relief is still available at the higher rate of 40% on personal contributions subject to the below maximum figures.
- Pension investment gains can grow tax free within the pension
- A Lump Sum of 25% of the retirement fund is available at retirement. This first €200,000 is tax free with the next €300,000 taxed at 20%. Anything over €500,000 is taxed at 40%.
There is no obvious tax efficient wealth accumulation alternative to a pension for retirement funding. The table below compares investing in a managed fund via a pension and via a direct investment.
|Less income tax relief||€40,000||€0|
|Net cost of investment||€60,000||€100,000|
|Return of 10%||€10,000||€10,000|
|Gross Value on maturity||€110,000||€110,000|
|Less Tax on Drawdown*||€42,900||€4,100|
|Net Value on maturity||€67,100||€105,900|
|Less cost of investment||€60,000||€100,000|
|Net return %||7.1%||5.9%|
*For the pension investment, we have assumed 25% can be drawn down tax free and the balance is liable to income tax at 52%. For the direct investment the return is subject to exit tax of 41%.
From the above example, it is clear that the benefit of tax relief on pension contributions still makes them attractive despite the tax liability incurred on drawdown. The most important point to make is that it is vital that individuals fund for retirement irrespective of whether there is a tax incentive available. Assessing how tax efficient a pension contribution is depending on the individual, their specific circumstances and the assumptions used. However, if there are further negative developments, such as a cut in the 41% exit tax charge or a reduction in the amount of tax free income you can draw from your pensions, the differential between pension and non-pension investments may become smaller.
During times of market volatility or below average investment fund performance, it is tempting for investors to look at alternative investments to pension funds as part of their retirement savings. Clients will often ask about alternatives to pension funds, but running through some basic calculations will quickly show the benefit from the tax relief on pension contributions and the tax-free lump sum at retirement. In addition to these tax benefits the exemption on investment income has a powerful compounding factor over the lifetime of a pension policy.
Pensions, while not as attractive as they have been in past, are currently still an efficient tax planning tool and should be part of an individual’s long term retirement plan.
Making a Pension Contribution.
Whether you are employed or self-employed will determine the type of pension vehicle into
Employees (including proprietary directors) who are members of an occupational pension scheme can make additional voluntary contributions to their occupational scheme or if their scheme allows for it they can make personal contributions to a standalone PRSA AVC.
Self-employed individuals or employees who are not members of an occupational pension scheme can make personal pension contributions to either a PRSA or a personal pension, including self invested personal pension
The amount of tax relief available of a personal contribution is subject to earning of €115,000 and the following aged related maximum contributions:
|Age||% of Earnings||Maximum contribution|
|60 and over||40%||€46,000|
Tax relief on regular pension contributions is given in the year in which they are made. However the Revenue does allow for individuals who make pension contributions after the end of a particular tax year but before 31st October of the following year, to claim tax relief on these contributions in the previous tax year. For example an individual can make a pension contribution on or before 31st October 2016 (extended to 10th November if you file your tax return online) and can claim relief on this contribution in the 2015 tax year assuming they have not maximized their contributions in 2015
If you or any member of your family has not yet maximized your pension contributions for 2015, there is still time to consider making a pension contribution. Please contact us at DLS Capital Management to discuss your options further.