Is a pension worth it if you're on the lower tax rate?

Maybrick

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I was recently talking to a relative and asked him, "Have you thought about starting a pension?" He surprised me by answering, "I've looked into it and I don't see the point." His position, roughly, is this:

He is just over 40, self-employed and earns around 30,000, so pays a lower income tax rate.
The tax relief he would get on a pension would be relatively small and eaten into by charges etc.
When he retires at 68, a typical annuity would pay around 4pc- so he needs to live to 93 just to get his original investment back.
He owns his home outright and has a healthy lump sum (something like 200,000) thanks to an inheritance, so no immediate cash worries.

In his own words, "I think I'll just keep saving - it's a guaranteed return, gives me more flexibility and is a hell of a lot less complicated."

I felt like I should have a counter-argument, but couldn't immediately think of one. Can anyone help?
 

noproblem

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In his own words, "I think I'll just keep saving - it's a guaranteed return".
Love to know what he means by this but in any case and answering your question and reminding you that time does fly. I'm 66 from earlier this year, had thought a little like the man you mentioned, but kept paying into the state system and now get almost €250.00 paid to me every single week. I've plenty of other investments too but in my mind the contributary pension that's given to me is money for old rope and is now proving a great investment. Oh, this is just my opinion.
 

The Horseman

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The benefit of a pension contribution is it attracts tax relief on the way in and Also on the way out up to certain amounts. As far as I know this lumpsum can be accessed once you turn 50. Comparisons between returns on existing investments v pension returns should be considered. Due to your relatives age I would not place too much reliance on the state pension. Unless your relative will have over 2000 prsi contributions by the time they retire they will get a prorata of the pension. This will probably change before your relative is due to retire. Remember we have a pensions time bomb.
 

Brendan Burgess

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At 40, he definitely should not be contributing to a pension which attracts tax relief at only 20%.

It will be taxed on the way out. So it could well be taxed at 20% or more when he receives it.

The thing to do is to continue saving. If he earns income at the higher rate in the future, then he can contribute to a pension.

If he has a mortgage, he should pay it off.

If he is renting, he should look at buying a house.

Brendan
 

The Horseman

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I disagree pension returns earn between 3 to 4% before tax per annum (this ignores the tax break on your contributions). Unless your investment is returning a greater yeild than that then you are earning less on your investment than on your pension pot returns.
 

Gordon Gekko

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I think he should be contributing to a pension.

He’s in a low USC band so it’s less relevant.

He can invest his net €80 and have his returns taxed. Or he can stick €100 into a pension for 25 years of tax-free growth. Then take 25% of it out tax-free. Then take 4% of his ARF out each year. Worst case scenario he’s paying 20% tax, no PRSI, and low rate USC. It’s the 25 years of tax free growth that’s the clincher.
 

adox

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At 40, he definitely should not be contributing to a pension which attracts tax relief at only 20%.

It will be taxed on the way out. So it could well be taxed at 20% or more when he receives it.

The thing to do is to continue saving. If he earns income at the higher rate in the future, then he can contribute to a pension.

If he has a mortgage, he should pay it off.

If he is renting, he should look at buying a house.

Brendan
So are you basically saying that anyone on a lower tax band shouldn’t contribute to a pension??

OP said he has no mortgage and 200k in savings. Surely some of that could be used to contribute to a pension.

I’m 52 and paying tax at 20% and currently maxing our contributions after ignoring it for many years and just letting my employer contribute.
 

Brendan Burgess

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Your money is tied up in a pension fund which you probably won't access for 13 years.

The only benefit you are getting is the 20% tax relief and the accumulation tax free.

If you are not going to have a taxable income at 65, then it's possibly worth it.

If you are going to have enough income to pay tax at 40% you would be crazy to contribute to a pension fund.

You put in €100 . It costs you €80.

You get €100 income. 25% tax free. So you will pay 40% tax on 75% or 30% .
So you get €70 out - or less if you are paying whatever they will be calling PRSI/Income Levy/ USC at that stage.

So you put in €80 and get €70 out.

If you will have income taxed at 20% when you retire, you will pay 20% on 75% or €15.
So you put in €80 to get €85 out. Hardly worth it.

If you will be taxed at 0% , you will put in €80 to get €100 out. That would be worth it. So very close to retirement when you know for sure that you will be taxed at 0%, then it's worth it.

It will also be subject to all the high costs and limitations of pension funds and the uncertainty over what might happen between now and then.

Brendan
 

cremeegg

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I was recently talking to a relative and asked him, "Have you thought about starting a pension?" He surprised me by answering, "I've looked into it and I don't see the point." His position, roughly, is this:

He is just over 40, self-employed and earns around 30,000, so pays a lower income tax rate.
The tax relief he would get on a pension would be relatively small and eaten into by charges etc.
This is a good point

When he retires at 68, a typical annuity would pay around 4pc- so he needs to live to 93 just to get his original investment back.
True, but there are many other options besides an annuity.

At 40, he definitely should not be contributing to a pension which attracts tax relief at only 20%.

It will be taxed on the way out. So it could well be taxed at 20% or more when he receives it.
I dont understand the reasoning here. [Crossed with your explanation]

With a pension you can get tax relief now then after 28 years of tax free growth pay tax on the drawdown; OR Tax now and tax every year for 28 years on your investment returns.

I disagree pension returns earn between 3 to 4% before tax per annum (this ignores the tax break on your contributions). Unless your investment is returning a greater yeild than that then you are earning less on your investment than on your pension pot returns.
This has nothing to do with pensions, the investment option you choose has (almost) nothing to do with wether its a pension investment or not.
 

cremeegg

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You get €100 income. 25% tax free. So you will pay 40% tax on 75% or 30% .
So you get €70 out - or less if you are paying whatever they will be calling PRSI/Income Levy/ USC at that stage.

So you put in €80 and get €70 out.
If you put €80 in (€100 invested) in and get 4% after charges, tax free that will be €300 after 28 years.

Outside a pension, if you put €100 in and pay 20% tax on a 4% return thats €241 after 28 years

So you put 80 in and get 300 out and pay tax on the drawdown. Not quite as bad as you suggest.
 

Marc

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Brendan is mathematically wrong here

I addressed this very point recently in this thread



I’m willing to go one further and say that for some people it’s worth paying into a pension even if you receive NO tax relief.

This takes up a whole chapter in my Irish Financial Planning book
 
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Maybrick

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Thanks for all those replies, plenty of food for thought there.

I have to say, though - if experts such as yourselves can disagree so strongly over what should be a relatively straightforward question, how on earth is the layperson supposed to make intelligent decisions? I appreciate that not everything can be spoon-fed and people have a responsibility to educate themselves - but in my opinion the Irish pension system is far more complicated and confusing than it should be.

On the substantive question, sorry to Marc and others I'm still far from convinced that anyone paying the lower rate of tax has much to gain from starting a pension (which is worrying because lower-paid workers are precisely those who the State should be encouraging to save). Please feel free to have another go at enlightening me!
 

Protocol

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My retired parents have incomes of approx 48-50k and pay 8-10% direct tax plus USC.

Don't assume that all pension income faces 20% tax.
 

Marc

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Protocol has hit the nail on the head here.

You need to stop focusing on your tax status today and focus on the likely tax you will pay in the future.

As I said, this subject is a whole chapter in my book so I agree it is poorly understood generally.
 

NoRegretsCoyote

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Cash saving for the long term seems daft in a world with near-zero interest rates.

Over 25 years equities generally deliver a better return.

Even a full state pension is only about half his income today.

I would put at least something into the pension, even without the tax relief.
 

Brendan Burgess

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Cash saving for the long term seems daft in a world with near-zero interest rates.

Over 25 years equities generally deliver a better return.
This has nothing at all to do with the question being asked as Creme Egg has already pointed out.

This has nothing to do with pensions, the investment option you choose has (almost) nothing to do with wether its a pension investment or not.
 

Fergal19

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The tax exempt status of the pension structure is generally worth more to the individual than the tax relief on the way in. The tax relief on contributions is just an added bonus.

You will generally be paying tax at a lower rate on pension payments especially when you factor in the tax free lump sum. For people at the standard rate they get tax relief at 20% but they will generally pay very little tax on future pension income and in a lot of cases will be zero due to the tax thresholds. For high income people they will get relief at the marginal rate but will generally pay tax at the marginal rate on the future income but when you consider the lump sum it reduces the effective rate.

So in essence you are deferring tax that is due now for a payment of tax in the future at a lower rate. This free use of the money is just an additional bonus to getting the tax exempt status of the structure.

If you are planning on doing long term savings, in my opinion the only way to do this is via a pension because of the tax free growth. So it doesn't matter what rate you pay tax at its still the best way to save in the long term.

For example take a proposed property investment of 200k with a potential rental profit of 10k per annum. If you do this personally you will generally lose half of this to the tax man each year. In a pension you keep the full amount. After 20 years you will have saved 100k from this investment if done personally and have saved 200k if done in a pension. Then when you factor in the bonus of the tax relief you have further increased your ROI. This is why the pension is the best structure for long term savings.
 

Fergal19

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I’m willing to go one further and say that for some people it’s worth paying into a pension even if you receive NO tax relief.

This takes up a whole chapter in my Irish Financial Planning book
The pension structure is also a great tool to protect assets for your children. It is probably the cheapest and best trust out there to keep assets out of reach or protect kids from themselves!

For example, make a gift to a child at say age 18 of 100k. Now they contribute the 100k to a pension and invest it in the Stockmarket. The beauty of the pension is that they can't get access to the funds till their retirement. Granted if they are savvy they can get it from age 50 but the point still stands. At age 65 the pot would be worth 3.7m at a rate of 8% per annum.

So no matter what your kids do with their inheritance this pot will be there for them to guarantee their future. Hopefully at this age they will be mature enough to manage wealth. Its a great option to have but rarely used.

Actually you probably don't even need much money to do this. ie you could from the birth of the child do the 3k each year gift and invest it into the stock market. In 18 years time at 8% that pot after tax would be circa 100k. Then at 18 put that lump sum into a pension as above.

So for a tiny commitment of 3k per year for 18 years you create 3.7 million. This is the real power of the tax exempt structure!
 

Daddy Ireland

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All sensible advice Fergal. Would have an issue with 8%. Perhaps historical returns but I have'nt personally got this return over the past 25 years in managed funds. More like 5%. Guess I must have been in the wrong funds.
 
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