As with most things in life, careful planning when it comes to your pension can reap rewards. Failing to do so, on the other hand, can mean you end up giving up more than you perhaps otherwise would have done.
While we often focus on contributions when talking about pensions, another important factor is how your pension savings will be taxed in retirement.
Tax shouldn’t be looked at in isolation. “It isn’t always about getting the lowest tax, it’s about getting it right for you,” advises chief executive of Acuvest John Tuohy. “You need to be careful about the tail wagging the dog; you need to be tax aware rather than tax driven.”
Nonetheless, as tax can have a big impact on the amount of money you get to live on in retirement, here are some steps to maximising your tax efficiency as much as you can.
Don’t rush to drawdown your pension(s)
The minute you access your pension is the minute tax becomes liable on it. Until then, it grows tax free — and the more there is in the fund, the greater the potential gains you might make.
While accessing your pension fund may give you your tax-free lump sum, drawing down from it just to have the money sit in your account may not make sense. Under deemed distribution rules, once you set up an approved retirement fund (ARF) — rather than taking out an annuity — you must draw down at least 4 per cent of the amount outstanding every year, a figure that rises to 5 per cent the year you turn 71. The Revenue Commissioners will levy income taxes on you on the basis you have drawn down this amount whether you do so or not, so it makes no sense not to do so whether you need the money or not.
If you have substantial savings, or another form of income, such as the State pension or an investment property, consider whether this will be sufficient to meet your needs, at least in the short term. As Liam Naughton, a director with Grant Thornton, notes, a lot of people retire at 60 but they don’t stop working entirely and may be supplementing their income with consultancy work etc.
Alternatively, they might have cash available to them from a termination payment, or a lump of money saved over time.
So if you have the money, a drawdown strategy whereby you access income you’ve already paid tax on first and don’t trigger the tax situation that goes with pensions, can make sense, says Tuohy. Once you open up that box you might be accessing your benefits but tax is also starting to kick in, he adds.
Now of course this approach isn’t for everyone. While Tuohy acknowledges that deferring your pension a year or two “mathematically might make a difference”, it may not be an option for many.
“Most people are not in that boat [where they can defer it],” he says. “I’d be saying get on with your life: do what you want to do.”
Think about your lump sum
When thinking about deferring your pension, you also need to think about when — and how — to access your pension lump sum. After all, one of the first things many of us will do when retiring is access our tax-free lump sum.
Just how much you get tax free will depend on the route you take. “Usually people are motivated to make the lump sum as big as they can,” says Tuohy. For those retiring with an ARF, this will be 25 per cent of the pension fund.
So someone with a pension fund worth €400,000 will be able to access a €100,000 tax-free lump sum.
But there might be a way of getting more than this tax free. Another calculation allows you get as much as 1.5 times your final salary, depending on years of service. So someone on a salary of €100,000 can get €150,000 tax free even if their pension fund was only worth €400,000.
“It’s quite possible that 1.5 times salary is going to be bigger than 25 per cent of the pot,” says Tuohy. “And in that case you would be motivated to consider it. But here’s the rub — you have to go buy an annuity or pension with the balance.”
So while the latter route could be more tax efficient in terms of the lump sum, given low returns available on annuities, the decision needs to be made in a much broader context than tax alone. As Tuohy advises, the best approach then is for people to look at it and do the calculation that gives them the highest lump sum.
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“They have to weigh up which gives the highest sum and what are the consequences of this,” he says. And it seems that despite the potentially greater tax savings on going the annuity route, most people are opting for an ARF and the 25 per cent tax-free lump sum.
“I don’t see a huge number of people wanting to take their DC (defined contribution) savings and buy an annuity. I don’t see that as often,” says Tuohy.
Remember also that there is an absolute ceiling that applies to tax-free lump sums. It stands at €200,000, which means the biggest pension fund that can guarantee a full 25 per cent drawdown tax free (under the ARF) route, is €800,000.
A lump sum drawdown of between €200,000 and €500,000 will incur tax at a rate of 20 per cent on the amount in excess of the €200,000 ceiling, which means that a €2 million pension fund is the maximum you can have to get the most out of the lump-sum regime. Above this rate, the level of taxation becomes more onerous, which means some people may stop funding at this level.
Then delay drawing it down
Obviously, many of us will need this lump sum for everyday costs etc, or for that dream holiday or new car. But if you don’t absolutely need it, and the money will simply lie resting in your bank account, you should think twice about liberating it as it might continue to grow if it remains invested in your pension account
“Everyone gets drawn to the tax-free lump sum and that’s totally understandable,” says Naughton. “But unless the rules change, that will always be there.”
So why rush to release it?
“You’ll get tax-free growth [leaving it invested] — you won’t get it anywhere else,” warns Naughton. “So try to increase the value of the fund before retiring it.”
Another advantage of this approach is that the later you leave it, the shorter timeframe it has to pay you out, so you won’t be stretching the fund from ages 60-95, for example.
“If you don’t need it, why would you take it?” asks Naughton.
Your fund might be worth €750,000 today, but €800,000 in a few years’ time — which would result not just in a bigger fund, but in a bigger tax-free lump sum also. Of course markets could go the other way too, which should also be considered.
Cash in your entire fund
It goes against much of the narrative of sensible provision for income in retirement but, on a case-by-case basis, availing of the 1½ times salary lump-sum option may mean you can clean out your pension fund entirely, says Naughton, making the requirement to buy an annuity with the remaining funds a moot point. If this description fits you, it’s worth considering this as a way of maximising tax savings on your pension.
A survey a few years ago showed the average defined contribution fund was of the order of about €100,000, which means that someone on a salary of about €66,000 could get their entire pension fund tax free if they were to go down this approach.
This means that cashing in your pension fund early and cleaning it out entirely can make sense from a tax perspective — but obviously care needs to be taken with the funds released!
Don’t rush to consolidate
While there may be many reasons to consolidate various pensions you may have from former employments, PRSAs etc, there is a good tax reason not to do so.
If you have just one pension fund, you must retire the whole fund at one time. But if you have several different funds, you can retire them at different ages. This means that you retain the potential for growth in your fund, and potentially, a greater tax-free lump sum.
The 25 per cent tax-free figure works on an aggregate basis across all your funds (up to the €200,000 maximum) but even so, keeping different pension funds offers greater flexibility for tax savings.
“The rule is €200,000 in your lifetime; but the route you go is up to you,” says Naughton.
You may even want to segregate your pension funds as you approach retirement, particularly if you’re close to the €2 million standard fund threshold. With a PRSA for example, you don’t have to retire it until you turn 75. So by using multiple PRSAs you can control when you draw down your funds better, leaving some to continue to grow.
Inheritance considerations
Another advantage of delaying when you access your pension fund is that it may pass tax free to your spouse, for example, in the event of your death.
With an ARF, the fund will pass too, but your spouse will be liable to income tax on drawdowns from it. But with an intact pension fund (provided the related employment has ceased), no tax will apply.
“If it’s structured in the right way, on your death 100 per cent of that estate goes to your spouse,” says Naughton.
Similarly if you have segregated your pension funds and haven’t accessed all of them before death, those “unopened” will offer substantial tax savings.
“Suddenly my spouse is better off because I didn’t open all the boxes,” says Tuohy.
