Thinking about the advantages and disadvantages of investing in pensions is conceptually difficult so I've been trying to figure out a way to simplify things.
Obviously there’s the easy case of when you get 40% tax relief on your contribution and the maximum tax you expect to pay on money from your pension when you retire is 20% tax + USC + PRSI. This is a no brainer. Free money.
Conceptually the hard thing to wrap your head around is if it’s a good idea to invest in your pension compared to other investment options at the point where the tax relief you receive on your contribution (40%) is less than the tax you pay on a portion of your pension in retirement, being up to 52% in some cases including USC and PRSI. Intuitively this doesn't feel right.
I think conceptualising this is easier if you take the fact that a first round of USC + PRSI will be paid on gross income for all possible investment options as a given, and then think of the income tax relief you receive on pension contributions as additional capital to invest.
Consider the following:
A = Value of Base Capital
B = Value of Income Tax Relief on A
When you invest outside a pension, you only invest the value of A.
When you invest in a pension, you invest the value of A and B.
In both cases, whether you invest in a pension or outside a pension, A is invested.
The operative differences in the two options’ ability to generate wealth are:
1. The mode of taxation and its ability to affect compounding
2. What portion of the investment is made subject to tax
3. The Headline Tax rate on the investment
4. The significance of B as additional capital to invest in the case of a pension
1. Mode of taxation and its ability to affect compounding
Compound interest works most effectively where investments are given time to grow before they are taxed.
You do not pay additional tax when you pay off a debt early as a form of investment e.g. paying off your mortgage early.
You only ever pay tax on a pension when you draw from it / die. The rest of the value of the pension can continue to compound, continually generating wealth, and potentially in excess of the amount you draw down from it each month. If your pension grows a lot this can preserve the value of your capital in perpetuity (until you die!).
CGT + Income Tax / Exit Tax investments are taxed as they grow, and are therefore less effective at harnessing compound interest than paying off debt or investing in a pension.
2. What portion of the investment is made subject to tax
In the case of every other investment apart from a pension, you only pay tax on growth from A (whether as dividends, CGT, exit tax etc..).
In the case of a pension, both your initial investment of A and B and any growth on them are fully subject to tax as part of the total pension pot when you draw down / die. You only ever pay this tax if you draw down the amount from your pension.
3. Headline Tax Rate
The headline tax rate on payments from a pension can range from 0% to 52% depending on your age and the size of your pension draw downs in any given year. You may also take tax free (in the case of DC / DB schemes) or 20% tax advantaged (in the case of DC schemes) lump sums. You will receive additional income tax credits at the point you draw it down. If you overfund your pension, you'll be hit with a 40% excess tax.
Tax on dividends from stocks, bonds, investment trusts etc. will range from 20% + applicable PRSI and USC rates to 40% + applicable PRSI and USC rates. Capital growth on these investments will be subject to 33% CGT, less CGT relief if you harness that.
Exit tax investments are charged at 41% tax on any growth.
4. The significance of B as additional capital to invest in the case of a pension
This is the real reason the pension will typically be the all round best investment option.
No other investment option in Ireland starts with the value of both A and B.
B is effectively additional free money for you to invest, bearing in mind point 2 above.
Obviously there’s the easy case of when you get 40% tax relief on your contribution and the maximum tax you expect to pay on money from your pension when you retire is 20% tax + USC + PRSI. This is a no brainer. Free money.
Conceptually the hard thing to wrap your head around is if it’s a good idea to invest in your pension compared to other investment options at the point where the tax relief you receive on your contribution (40%) is less than the tax you pay on a portion of your pension in retirement, being up to 52% in some cases including USC and PRSI. Intuitively this doesn't feel right.
I think conceptualising this is easier if you take the fact that a first round of USC + PRSI will be paid on gross income for all possible investment options as a given, and then think of the income tax relief you receive on pension contributions as additional capital to invest.
Consider the following:
A = Value of Base Capital
B = Value of Income Tax Relief on A
When you invest outside a pension, you only invest the value of A.
When you invest in a pension, you invest the value of A and B.
In both cases, whether you invest in a pension or outside a pension, A is invested.
The operative differences in the two options’ ability to generate wealth are:
1. The mode of taxation and its ability to affect compounding
2. What portion of the investment is made subject to tax
3. The Headline Tax rate on the investment
4. The significance of B as additional capital to invest in the case of a pension
1. Mode of taxation and its ability to affect compounding
Compound interest works most effectively where investments are given time to grow before they are taxed.
You do not pay additional tax when you pay off a debt early as a form of investment e.g. paying off your mortgage early.
You only ever pay tax on a pension when you draw from it / die. The rest of the value of the pension can continue to compound, continually generating wealth, and potentially in excess of the amount you draw down from it each month. If your pension grows a lot this can preserve the value of your capital in perpetuity (until you die!).
CGT + Income Tax / Exit Tax investments are taxed as they grow, and are therefore less effective at harnessing compound interest than paying off debt or investing in a pension.
2. What portion of the investment is made subject to tax
In the case of every other investment apart from a pension, you only pay tax on growth from A (whether as dividends, CGT, exit tax etc..).
In the case of a pension, both your initial investment of A and B and any growth on them are fully subject to tax as part of the total pension pot when you draw down / die. You only ever pay this tax if you draw down the amount from your pension.
3. Headline Tax Rate
The headline tax rate on payments from a pension can range from 0% to 52% depending on your age and the size of your pension draw downs in any given year. You may also take tax free (in the case of DC / DB schemes) or 20% tax advantaged (in the case of DC schemes) lump sums. You will receive additional income tax credits at the point you draw it down. If you overfund your pension, you'll be hit with a 40% excess tax.
Tax on dividends from stocks, bonds, investment trusts etc. will range from 20% + applicable PRSI and USC rates to 40% + applicable PRSI and USC rates. Capital growth on these investments will be subject to 33% CGT, less CGT relief if you harness that.
Exit tax investments are charged at 41% tax on any growth.
4. The significance of B as additional capital to invest in the case of a pension
This is the real reason the pension will typically be the all round best investment option.
No other investment option in Ireland starts with the value of both A and B.
B is effectively additional free money for you to invest, bearing in mind point 2 above.
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