Pensions vs. other forms of investment

E

Ent319

Registered User
Messages
120
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.
 
Last edited:
huskerdu said:
It’s not true that you pay 52% tax on your pension .
A 67 year old with a pension income of €50k pays @ €9k in income tax and USC. That’s an effective rate of 18%.
Click to expand...
And it gets even better when you account for the tax-free lump sum.

@Ent319 - there is really nothing conceptually difficult here - investing through a pension beats investing outside a pension hands down.
 
Ent319 said:
No other investment option in Ireland starts with the value of both A and B.

B is free money for you to invest that you have to pay tax on as part of the total pension pot.
Click to expand...

I would disagree with this part of your analysis. Outside a pension wrapper A is not taxable, although gains on it are. Inside, A is taxable. So B is not free money, the cost is the tax that will be paid on A.

If tax free or at 20%, the cost is obviously low but if you're investing extra in a pension knowing that extra part will be taxed at 40% + in the future there's not much benefit.
 
Thanks for your comments everyone. I've tidied up the wording in the main post and aimed to address the points you've raised.

The main focus of this thread was me trying to wrap my head around whether its worthwhile to make contributions if you're paying 40% income tax and expect to pay similar or higher levels of tax on drawdowns from your pension when you retire.

Given our progressive income tax system, there will always clearly be a sizeable portion of any pension drawdown that will be subject to lower levels of income tax and/or USC.

Sarenco said:
And it gets even better when you account for the tax-free lump sum.

@Ent319 - there is really nothing conceptually difficult here - investing through a pension beats investing outside a pension hands down.
Click to expand...

As a counterpoint: the volume of threads and discussions on this topic on askaboutmoney over the years, in particularly comparing paying off your pension vs. paying off your mortgage, would appear to suggest otherwise.
 
Last edited:
Ent319 said:
The main focus of this thread was me trying to wrap my head around whether its worthwhile to make contributions if you're paying 40% income tax and expect to pay similar or higher levels of tax on drawdowns from your pension when you retire.
Click to expand...
When you account for -

1. The €200k tax-free lump and the 20% tax rate on the next €300k of the 25% lump sum;

2. Personal tax credits;

3. The 20% income tax band (currently applies up to €42k);

4. No PRSI once in receipt of the State (Contributory) Pension; and

5. The State (Contributory) Pension is exempt from PRSI and USC;

then the blended, or effective, tax rate on drawdowns from a pension will always be less than the marginal tax rate, right up to the point where your pension reaches the standard fund threshold.

Or, to put it another way, the tax relieved on contributions will always exceed the tax payable on drawdowns.

And that ignores the huge advantage of tax-free compounding within a pension wrapper.

It really is a no brainer - investing through a pension always trumps investing outside a pension structure.
 
Sarenco said:
And that ignores the huge advantage of tax-free compounding within a pension wrapper.
Click to expand...

And that ignores the fact that you could be hit for 40% + tax on the 'tax-free' compounding on drawdown, in the circumstances the OP outlined.

You quoted the main point of the OP's thread but ignored it in your reply. They have already acknowledged the clear advantages of investing in pensions and no-one has disputed those.
 
llgon said:
And that ignores the fact that you could be hit for 40% + tax on the 'tax-free' compounding on drawdown, in the circumstances the OP outlined.
Click to expand...
But the blended tax rate on drawdown is always less than the marginal rate for the reasons already outlined.

That’s the key point - you have to look beyond the headline marginal rate.
 
Sarenco said:
When you account for -

1. The €200k tax-free lump and the 20% tax rate on the next €300k of the 25% lump sum;
Click to expand...
This wouldn't be the case on a DB pension where the max tax free lump sum is €200K. You'd also need a salary of €135K to get that. You don't get the option of taking the €300K at 20% from your AVC if you're on a DB Pension. The general point you're making regarding the impact of lump sums still stands.
Sarenco said:
2. Personal tax credits;
Click to expand...
Now noted in the OP - good point.
Sarenco said:
[...] then the blended, or effective, tax rate on drawdowns from a pension will always be less than the marginal tax rate, right up to the point where your pension reaches the standard fund threshold.

Or, to put it another way, the tax relieved on contributions will always exceed the tax payable on drawdowns.
Click to expand...
I'm not sure if it makes sense to look at it this way.

Let's say you're dealing with €100 Gross pay. €60 is A (Base Capital) and €40 is B (your income tax relief).

The fact that B has come from income tax relief is irrelevant. It could have come from anywhere. What matters is whether by investing A and B via a pension you are in a better financial position at the end of the day than you would have been in light of the opportunities to invest A only. This might have been what you were aiming to say. I'll think a bit more.
 
Sarenco said:
But the blended tax rate on drawdown is always less than the marginal rate for the reasons already outlined.

That’s the key point - you have to look beyond the headline marginal rate.
Click to expand...

Take the case of somebody who has already enough pension provision to maximise their tax free lump sum and provide income in retirement to bring them past the marginal tax rate.

In deciding whether to make extra contributions on top of this, the marginal rate is all that matters. Blended/effective tax rates are only a distraction as far as this particular decision is concerned.
 
llgon said:
In deciding whether to make extra contributions on top of this, the marginal rate is all that matters. Blended/effective tax rates are only a distraction as far as this particular decision is concerned.
Click to expand...
I disagree.

Say you are lucky enough to retire at 66 with a pension pot of €1.6m. You decide to take the full 25% lump sum and purchase an annuity of €50k pa with the balance.

You only pay €40k tax on the lump sum and €9k income tax and USC. That’s an effective rate of just 16%.

Sure you pay some income tax at the marginal rate on the drawdown.

So what? It’s the over all tax position that matters.
 
BigPineapple said:
The only downside to pension is liquidity/time.. can't draw down until certain age when you might need money quickly now.. other than that, pension is the main show in town really.
Click to expand...
I see it more as an inherent feature than a downside and its the flipside of compounding so its a necessary feature.
 
The OP himself said that…
Ent319 said:
The main focus of this thread was me trying to wrap my head around whether its worthwhile to make contributions if you're paying 40% income tax and expect to pay similar or higher levels of tax on drawdowns from your pension when you retire.
Click to expand...
…and that’s the point I addressed.

You said…
llgon said:
In deciding whether to make extra contributions on top of this, the marginal rate is all that matters.
Click to expand...
…which is flat out wrong.

I’ve no idea what other point you are trying to make now but frankly it comes across as sour grapes.
 
Sarenco said:
I disagree.

Say you are lucky enough to retire at 66 with a pension pot of €1.6m. You decide to take the full 25% lump sum and purchase an annuity of €50k pa with the balance.

You only pay €40k tax on the lump sum and €9k income tax and USC. That’s an effective rate of just 16%.

Sure you pay some income tax at the marginal rate on the drawdown.

So what? It’s the over all tax position that matters.
Click to expand...
It's not the overall tax position that matters though. Turning back the clock, what matters is whether investing A + B in your pension at the time you invested was more economical than the other options you could have invested for A only.

Also, I'd point out again that the position is very different for someone in a defined benefit scheme who can only pull a tax free lump sum and not the additional amount at 20%. They can't take a large chunk out of their pension in a tax-advantaged way (20%) to reduce their tax liability later on.

For example, a diligent investor on a career average defined benefit scheme could have a pension worth €2,000,000 – 800,000 from the occupation pension and 1,200,00 in an AVC. The Occupational Pension might pay €40,000 PA for that + Lump Sum. The person may only spend €60,000 topping up their lump sum. This leaves you with an AVC worth €1,140,000. If ARFd annual drawdowns would have to be €45600 per year. Your income is now €85600 per year and you're paying 40% + 8% USC on portions of that.

Even if the AVC was a slightly more modest / reasonable 500,000 (20,000 at 4%) you'd face a similar problem. 40% tax + USC on aspects of your income. Maybe if you'd reduced that you could get the lower USC rate when you're 70.

So I don't think it's quite as cut and dry as you're making out. If you're making pension contributions towards the end of your career your ability to avail of compounding is decreased (#1), the money you've put in your pension, including A and B, is made subject to tax again, albeit said tax is only paid when you draw down / die (#2), the headline tax rate on portions of your return from what you've invested is extremely high (#3) but you do get your extra money to invest from B (#4).
 
Last edited:
Also I would point out – that while I was trying to wrap my head around the tax piece as part of this thread – the conclusion I came to (explored in the OP) was that this is actually a much more complex issue than looking at the headline rates of tax on the way in vs. on the way out.
 
Ent319 said:
IFor example, a diligent investor on a career average defined benefit scheme could have a pension worth €2,000,000 – 800,000 from the occupation pension and 1,200,00 in an AVC. The Occupational Pension might pay €40,000 PA for that + Lump Sum. The person may only spend €60,000 topping up their lump sum. This leaves you with an AVC worth €1,140,000. If ARFd annual drawdowns would have to be €45600 per year. Your income is now €85600 per year and you're paying 40% + 8% USC on portions of that.
Click to expand...
In that scenario (which looks wholly unrealistic to me), you would have an effective tax rate of 26.5% on drawdowns.

Still lower than the 40% tax relieved on the contributions.

And you would have had the benefit of tax-free compounding to get to that position.

Again, this really is not a complicated issue.

Pensions are by far and away the most tax-efficient way to save for retirement - right up to the standard fund threshold.
 
You must log in or register to reply here.
Back
Top