Key Post What is the maximum I should contribute to a pension fund?

[Brendan Burgess]

This has come up in a few different threads, so it's worth teasing it out here.

Tony Gilhawley has an excellent piece on it here: [broken link removed]

To be corrected for the 40% tax rate, not 41%

The tax benefit of pension contributions is often exaggerated

Tax benefits

• income tax relief on contributions
• tax-free growth within the fund
• on retirement, 25% tax-free lump sum up to €200,000
• ARF planning opportunities

But the pension is subject to income tax and USC when it's being paid to you.


In my opinion, you should aim to have a fund of around €800,000 on retirement, but no more

The maximum tax efficiency is to have a fund of €800,000.

pension contribution|€100
Tax relief| 41%
|
|
Payment on retirement|€100
Tax-free|€25
Remaining|€75
Income tax at 41%|€31
USC @ 7%|€5
Total tax|36% of €100

For the bit in excess of €800k :

Note: I have used the 3.5% USC rate.

pension contribution|€100
Tax relief| 41%
|
|
Payment on retirement|€100
€25 @ 20%|€5
€75 @ 41%|€31
USC €75 @ 7%|€5
Total tax|41% of €100

So, you are getting tax relief at 41% but paying tax at 41% on drawdown.

Other reasons for limiting your pension contributions to a target fund of €800k

• Pension funds have very high charges which reduce the return
• You can't access the money until retirement
• The tax rules may change e.g. the €200k tax-free amount may be reduced further.
• Tax rates and USC rates may be increased in future

Some reasons for targeting a fund higher than €800k

• If your other income is low, you may not be on a marginal rate of 41% on your retirement income
• Tax and USC rates may be reduced in future
• The €200k tax-free amount may be increased in future
• Pension funds are treated favourably in insolvency
• If you die, your estate will receive the fund tax-free
• While you get tax relief now at 41%, this may be reduced at a later stage

 

[Homer]

Sorry to point this out, but the figures in the second table add up to 41%. You state this below the table, but show 39% in the table.

Another point that needs to be borne in mind is that payments from an ARF prior to State pension age are subject to PRSI.

 

[Sarenco]

Thanks Brendan but I'm still struggling with the numbers.

Let me give an example that I hope is reasonably plausible:

Say over the course of his working life, a higher rate tax payer makes total contributions to a personal pension of €600,000 and at retirement his pension pot has grown to €1,000,000. At 60 he decides to retire, takes the maximum tax free lump sum of €200,000, invests €63,500 in an AMRF and invests the balance in an ARF. He then makes the minimum required withdrawals from the ARF, which in his first year of retirement equates to €29,460 (4% of €736,500). €29,460 is obviously well below the standard rate tax ceiling and annual tax credits will be available. This also ignores the fact that the funds within the AMRF and ARF can continue to grow tax free after retirement and any estate planning opportunities.

Am I missing something?

 

[TRS30]

Thanks Brendan but I'm still struggling with the numbers.

Let me give an example that I hope is reasonably plausible:

Say over the course of his working life, a higher rate tax payer makes total contributions to a personal pension of €600,000 and at retirement his pension pot has grown to €1,000,000. At 60 he decides to retire, takes the maximum tax free lump sum of €200,000, invests €63,500 in an AMRF and invests the balance in an ARF. He then makes the minimum required withdrawals from the ARF, which in his first year of retirement equates to €29,460 (4% of €736,500). €29,460 is obviously well below the standard rate tax ceiling and annual tax credits will be available. This also ignores the fact that the funds within the AMRF and ARF can continue to grow tax free after retirement and any estate planning opportunities.

Am I missing something?

If they are married at age 65 they can have an income €36,600 and pay no tax at all. They would however pay 40% on anything over this amount.

 

[Brendan Burgess]

Sorry to point this out, but the figures in the second table add up to 41%.

No need at all to apologise. I am delighted to have my errors pointed out. I got interrupted by a phone call when revising that table.

Another point that needs to be borne in mind is that payments from an ARF prior to State pension age are subject to PRSI.

I want to summarise the general principles rather than set out all circumstances. How often does that arise? If I set up an ARF at 50, must I take 4% a year? If so, then this would be a factor.

 

[Brendan Burgess]

Hi Sarenco

Interesting point. You argue that most of his income will be taxed at 20% rather than 41%.

He will presumably have the state pension as well.

If he was earning enough to contribute €600k, he probably has other savings outside the pension fund which are giving him a taxable income.

In practice, will people who were earning a large salary, cut their income down to the minimum drawdown of 4%? They probably will if they have other savings.

20% tax band for married couple|€43,000
less state pension| €22,000
Pension taxable at 20%|€23,000
Taxable at 40%| €7,000

 

[TRS30]

Hi Sarenco

Interesting point. You argue that most of his income will be taxed at 20% rather than 41%.

He will presumably have the state pension as well.

If he was earning enough to contribute €600k, he probably has other savings outside the pension fund which are giving him a taxable income.

In practice, will people who were earning a large salary, cut their income down to the minimum drawdown of 4%? They probably will if they have other savings.

20% tax band for married couple|€43,000
less state pension| €22,000
Pension taxable at 20%|€23,000
Taxable at 40%| €7,000

Brendan

Are you using the example of someone under 65?

I was under the impression that anyone over the age of 65 (if married) could have income up to €36,600 tax free and then pay the higher rate on anything over that.

 

[Sarenco]

Hi Sarenco

Interesting point. You argue that most of his income will be taxed at 20% rather than 41%.

Thanks Brendan.

Actually in my example no element of his drawdowns will ever be taxed at the marginal rate (under current rules, obviously), whereas he received relief at the marginal rate on all contributions.

He may well receive income from sources other than his pension on retirement that may be subject to income tax at the marginal rate but I don’t see how that impacts the tax efficiency of his pension arrangements.

Surely the main goal of a pension from a tax planning perspective is to pay tax at a lower effective rate on drawdown (taking annual tax credits into account) than the rate of tax that was relieved in the first place? Even if his pension fund is sufficiently large (but less than the €2 million SFT) that he has to pay tax at the marginal rate on an element of any amount drawn down, it would still be efficient from a tax perspective if his effective tax rate at the time of any such drawdown (including PRSI and USC), less any available credits, is lower than the marginal income tax rate at the time of any contribution (I assumed in my example that all contributions would otherwise have been subject to income tax at the marginal rate). The same logic would apply if he voluntarily chose to draw down his funds at a level that attracted some income tax at the marginal rate - as long as the effective rate of tax paid on the drawdown is less than the amount originally relieved, he is still ahead.

It should also be borne in mind that his pension fund can grow without any tax drag (both before and after retirement) and this could become very significant over a prolonged time period. For example, some of his pension fund could remain invested for 65 years if he started contributing at 25 and dies at 90 without exhausting his fund. The efficiency of a pension from an estate planning perspective could also be significant depending on an individual’s personal circumstances or desire to leave a legacy to a favourite charity, etc.

 

[Sarenco]

He will presumably have the state pension as well.

/QUOTE]

Yes, although the retiree in my example would have to wait a few years (I assumed he retires at 60) and his ARF (and therefore the actual amount of any minimum required drawdowns) may well have reduced at that stage as a result of market movements and/or the impact of his drawdowns. In any event, I don’t really see how any additional income, whether in the form of a state pension or otherwise, has any impact on the tax efficiency of his private pension arrangements.

As a side comment, I personally think it is prudent to assume that the contributory state pension in its current form will either cease to exist within many of our lifetimes or at least in future will be substantially less generous in real terms. If this turns out to be overly pessimistic then the retiree in my example will treat the state pension (net of tax, if any) as an added bonus (roll out the Wurther's Originals!).

 

[Sarenco]

If he was earning enough to contribute €600k, he probably has other savings outside the pension fund which are giving him a taxable income.

In practice, will people who were earning a large salary, cut their income down to the minimum drawdown of 4%? They probably will if they have other savings.

…or he may have a part-time job/a working spouse/receive a profit share from a business/receive a substantial inheritance – there are any number of reasons why an individual may wish to defer or limit drawdowns. Also, don’t forget that the hero of my example still has a tax free lump sum of €200,000 to fund his carefree lifestyle!

I agree that total pension contributions of €600,000 is probably at the high end of the scale but I think it is at least plausible that a reasonable proportion of higher rate taxpayers will make total contributions at that level over, say, a 40 year working career. My example also implies a very conservative rate of return - to take another example, a weekly contribution to a pension of €100 per week over 40 years (€208,000 in total) will result in a final pension pot of well over €1,000,000 if you assume an annualised return, net of fees, of 7 per cent (for reference, the total annualised return of the S&P 500 for the 40 years to October 2014 was over 12 per cent).

In any event the precise numbers are not that important - I am really just trying to tease out the financial rationale for the proposition that anybody should ever limit allowable pension contributions or the amount of any resulting pension pot (assuming the €2 million ceiling is nowhere in sight), subject obviously to being in a position to meet all other financial commitments.

 

[Sarenco]

In practice, will people who were earning a large salary, cut their income down to the minimum drawdown of 4%? They probably will if they have other

]

Finally, as regards my retiree's plan to draw down from his ARF at a rate of 4 per cent per annum, there is a fairly developed body of academic literature in the US that suggests that 4 per cent, adjusted for inflation, represents the maximum withdrawal rate that a balanced portfolio can be reasonably expected (but not guaranteed) to survive a thirty year draw down period. My retiree has looked after himself down through the years and fully expects to live for at least 30 years from retirement at 60. As you have probably gathered at this stage, my retiree is a very prudent man but you wouldn't necessarily want to meet him for a pint!