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Perspectives

Do pension contributions still make sense?

For many years, self-employed and PAYE individuals subject to the higher rate of tax have viewed a contribution to a Personal Pension, a PRSA or an Additional Voluntary Contribution (AVC) (herein ‘pension’) as a useful tax planning tool.

However, due to recent developments, there are now doubts as to the rationale behind making a discretionary pension contribution. Individuals are considering alternative wealth accumulation vehicles, such as fixed term deposit accounts or life assurance investment bonds. This article will evaluate if it still makes sense to make a discretionary pension contribution.

Irish pension developments
Recent developments 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 listed below:

  • An annual pension levy of 0.6% of the fund value to 2014 (industry speculation suggests it will continue past 2014)
  • All individual contributions are now subject to PRSI and the USC
  • The maximum salary used to calculate a tax efficient individual contribution has been reduced from €254,000 to €115,000; the table below outlines the age related maximum contributions

Age

% of Earnings

Maximum contribution

Under 30

15%

€17,250

30-39

20%

€23,000

40-49

25%

€28,750

50-54

30%

€34,500

55-59

35%

€40,250

60 and over

40%

€46,000

  • The maximum lifetime tax free lump sum limit has been reduced from €1.35 million (2010) to €200,000
  • The maximum lifetime pension fund has been reduced from €5.4 million (2010) to €2.3 million (speculation suggests a further reduction in the next budget)
  • The annual Approved Retirement Fund (ARF) drawdown has increased from 0% (2006) to 6%
  • The introduction of the USC has impacted ARF holders. The table below outlines the relevant rates.
    Age Income tax PRSI USC Total

Age

Income tax

PRSI

USC

Total

To age 66

41%

4%

7%

52%

66-69 

41%

0%

7%

48%

70+

41%

0%

4%

45%


Do pension contributions still make sense?
While recent developments do reduce the tax efficiency of pension contributions, there are still some significant positives:

  •  Income tax relief is still available at the higher rate of 41% on contributions
  •  Investment gains can grow tax free within the pension
  •  A Tax Free Lump Sum (TFLS) of 25% of the retirement fund is available at retirement (€200,000 maximum)
  • The balance of the retirement fund (after the TFLS has been withdrawn) is unlikely to be subject to the higher rate of tax over the full drawdown period (see above table)
  •  There is no obvious tax efficient wealth accumulation alternative to a pension for retirement funding. The table below compares three options for a higher rate tax payer.

 

Pension

Deposit account

Life assurance investment bond

Gross earnings

€1,000

€1,000

€1,000

Less income tax @ 41%

  • €410
  • €410
  • €410

Less PRSI @ 4%

  • €40
  • €40
  • €40

Less USC @ 7 %

  • €70
  • €70
  • €70

Earnings net of tax

€480

€480

€480

Cost of Contribution/ Deposit (A)

€480

€480

€480

Income tax relief*  (B)

€334

Nil

Nil

Total investment amount (C)

€814

€480

€480

Annual tax on growth

Nil

30%

Nil

Tax on drawdown

75% of pension fund is subject to tax rate of 52% – 45% (age dependant)

Nil

33% of growth

*Income tax relief is based on the contribution of €480.

The above table illustrates the net cost of the investment (A) is the same to the individual for each option, (i.e. C - B = A).  However, the total amount the individual actually invests (C), is greater for the pension due to the tax relief enhancement (B).

Case Study –AVC versus Deposit account
A 49 year old employee is considering a discretionary pension contribution or a fixed term deposit.  The individual intends retiring at 65 years of age.  

 

Pension 

Deposit account

Available earnings net of tax

€13,800

€13,800

Cost of Contribution/ Deposit

€13,800

€13,800

Income tax relief

€9,590

€0

Total investment amount

€23,390

€13,800

Investment return to retirement at 4% p.a.

€15,628

€7,269

Value at retirement

39,018

21,069

Net value (after tax)

€23,801*

€21,069

*Tax rate of 52% assumed for full balance of retirement fund after TFLS

The individual would have to pay an effective rate of tax of 59.9% or higher on the balance of retirement fund (after the TFLS is withdrawn) for the deposit account to be a more tax efficient option.

As highlighted above the combined rate of tax on drawdowns from the balance of the retirement fund is 52% at 65, dropping to 45% from 70 years, therefore the pension option is more tax efficient for this scenario.Please see the assumptions used for the above examples below.

Conclusion

It is vital that individuals fund for retirement irrespective of whether there is a tax incentive available. The current state pension of €11,975.60 is unlikely to provide an individual with their desired level of income in retirement and private wealth will undoubtedly be required to supplement retirement income.  

Assessing how tax efficient a pension contribution is depends on the individual, their specific circumstances and the assumptions used. Factors including investment returns and future legislative changes are impossible to predict. 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.  

However, if there are further negative developments, such as a cut in the full 41% income tax relief, then the rationale behind making an individual pension contribution should be revisited.

Assumptions

Please note the above analysis does not constitute advice, is indicative only and is subject to change.  It is assumed the individual does not qualify for the 65 year old married €36,000 income exemption, pays tax at the higher rate (currently 41%) and that there is no change to current Irish legislation.

The following have not been factored into the analysis: inflation; capital liquidity; other tax reliefs/ credits; Approved Minimum Retirement Funds; the 0.6% levy on Pensions for 2013 and 2014; Pension Board fees and other charges.

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