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Why are some people paying income tax at almost 70%? Their pension pot is too big

Saving for a pension is encouraged but saving too much can land you with an unwelcome tax bill, as high earners in the public and private sectors have discovered

There have been murmurings for some time now that the current threshold – at €2 million – has failed to keep up with inflation. Photograph: iStock

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Fiona Reddan
Tue Feb 27 2024 - 05:00

Back in 2022, about 250 people paid tax in Ireland at a rate of almost 70 per cent. Why? They had managed to create an outsize pension fund, which was hit by an excess tax rate of 40 per cent.

Now a review is under way, which aims to assess the appropriateness of the current €2 million ceiling under the so-called standard fund threshold (SFT). But will it, as so many have lobbied for, be increased? Or could it in fact be reduced further?

Last week, the Department of Finance’s public consultation on the threshold closed, with the responses expected to help inform a report currently under way – led by Dr Donal de Buitléir, with support from the Department of Finance – into the current regime.

While there have been murmurings for some time now that the current threshold – at €2 million – has failed to keep up with inflation etc, the issue came to a head last December when it was cited as a reason why no senior garda applied for the post of deputy commissioner. Why enjoy the benefits of a high-paying public sector job, it was argued, if you end up giving almost 70 per cent away above a certain limit?

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After all, it hasn’t always been this way.

Until 2005, there was no limit on how much people could secure tax relief on as they built up a pension fund which would then be subject to the normal rates of taxation in retirement as it was drawn down. That year, the government introduced a standard fund threshold for the first time at a level of €5 million, “with the purpose of addressing excessive pension accrual”, according to current Minister for Finance Michael McGrath. As it was index-linked, the threshold increased each year, reaching some €5.4 million in 2010.

Once a pension fund went over this threshold, anything above the threshold became subject to a “chargeable excess”, or additional taxation, of some 40 per cent.

In an era of austerity, however, such a fund threshold level was deemed too lofty and, in December 2010, it was slashed back to €2.4 million before being cut once more in January 2014 to €2 million, where it has since remained.

While the legislation does allow for an increase in the standard fund threshold and any individual personal fund threshold for those whose pension funds were in excess of the €5 million limit originally in line with earnings, this increase is at the discretion of the Minister for Finance, and such sanction has not been forthcoming since 2008.

Last autumn, McGrath told the Dáil that “it is not the case that increases in the CPI [consumer price index] or other measures of purchasing power should necessarily automatically result in an increase to the SFT”.

Had the threshold been index-linked since 2014, the Irish Tax Institute says it would currently sit at around €2.4 million.

How does it work?

Once you hit the standard fund threshold, any income your pension fund generates over this level is subject to a new, additional tax rate of 40 per cent.

So, for example, if your fund is worth €2.1 million, then some €40,000 of this will be paid out in tax. The remaining €60,000 will go towards your approved retirement fund (ARF), for example. However, when you draw this down as retirement income, you will have to pay income tax, USC and potentially PRSI (depending on your age and whether or not you have drawn down your State pension). That means the €100,000 excess will be facing a tax bill of about 69 per cent, according to the Society of Actuaries in Ireland.

But there may be ways around it, even at the current level. If you draw down your pension fund earlier than you might have otherwise – perhaps when it reaches €1.8 million, for example – it will pass the standard fund threshold test and the funds can continue to grow if they are invested in an ARF, for example, with drawdowns taxed in the normal manner, thus avoiding the excess tax.

Moreover, if you end up paying tax on your tax-free lump sum (ie any amount between the tax-free threshold of €200,000 and €500,000), this can be used as a credit against excess tax. It means the effective SFT limit can, in fact, be as high as €2.15 million before it gets hit with the excess charge.

[ KPMG calls for increase in tax-free pension ceiling and lump sums ]

High-ranking public sector workers, such as medical consultants and judges, are most likely to confront the issue. Others who might hit the limit include very high earners and those who have been very lucky with their investments.

In its response to the consultation process, the Society of Actuaries says that members of final salary-defined benefit schemes, with high salaries and long service, “are most likely to be affected by the SFT”, suggesting that a current retiree from the public service with an accrued pension by that age of just over €70,000 a year (plus a tax-free lump sum of three times their salary) could breach the SFT.

Increase or no?

In its 2022 report, the Commission on Taxation and Welfare recommended the “periodic benchmarking” of the standard fund threshold “to an appropriate and fair level of estimated retirement income”. But what should this be?

The Society of Actuaries would like to see the threshold linked to the consumer price index “to maintain the real value of pension savings and with recognition of the passage of time since the previous adjustment”, arguing that the threshold affects “a broader contingent of senior employees in the private and public sector” than it did when first introduced. It suggests that any adjustments be upward only.

The American Chamber of Commerce in Ireland in its submission suggests that “a strategic reassessment” will help Ireland’s position as a destination of choice for foreign direct investment and for talent to live and work.

The Pensions Council gives more specific figures; it suggest that the €2 million could increase to €2.9 million, or €2.15 million would increase to €3.1 million.

There is also a difference currently in how public-sector pensions can be treated versus private sector, and a number of responses call for a change to this.

The Consultative Committee of Accountancy Bodies – Ireland, for example, urges that consideration be given “to harmonising the treatment of public and private sector pensions as regards the application of the standard fund threshold rules when the limits are breached”.

The Irish Tax Institute, meanwhile, says that the threshold has now become “penal in nature and a revenue-raising measure” because the threshold has not been indexed in the 10 years since it was set at its current level.

Not all the responses to the consultation have looked for the threshold to be increased; some want it abolished altogether.

The Senior Civil Service Association, which represents the interests of assistant and deputy secretaries general in the Civil Service, has argued that it should be removed, “as other suitable limits can control the amount of annual funding of individual pensions”.

In its submission, the association says the current threshold has, in some cases, reduced “the pool of candidates willing to go forward for more senior positions or encouraging those undertaking such roles to leave earlier than they would have otherwise”.

[ Pension rules to be reviewed as gardaí say fund threshold regime is forcing early retirements ]

If it was to be retained, the group argues, it should be “revised upwards to a level more reflective of income and pension benefits in the economy generally for senior management, while retaining the disincentive to fund excessive pension entitlements. It should be updated regularly thereafter to reflect movement in such incomes.”

The association has also called for a reduction in the excess tax charge to just 20 per cent, “similar to that charged in respect of lump sums”.

Among those happy to keep the threshold, not everyone is calling for it to be increased. After all, it only impacts on a small number of well-remunerated individuals – fewer than 300 retirees find themselves paying it each year.

Sinn Féin has called for the threshold to be lowered to €1.5 million, a move which, it says, could yield almost €400 million in additional revenue for the exchequer in a year if combined with lowering the earnings contributions cap for allowable reliefs to €60,000 from its current €115,000.

Back in 2021, the ESRI suggested that cutting the threshold could see the Government raise additional tax revenues.

There are, of course, many other tax allowances that have not increased in quite some time; the capital gains tax allowance, for example, which arguably impacts on far more people, has remained at just €1,270 for quite some time now.

And international norms suggest the Irish limit is already generous; in the UK, for example, a similar limit is only about £1 million, although last year, the government there announced that it would abolish this limit.

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