Making Cents: Pension income is heavily taxed, right? Wrong!

THERE are lots of myths surrounding pension planning, and perhaps misunderstanding is a better way to describe them, and one of the biggest I find is in the area of tax relief.

And this is a subject I wrote about before but I think it’s time I covered it again.

Because I’m not so sure whether people get or appreciate how incredible and generous the relief on contributions are, particularly if you pay income tax at the marginal rate.

And there’s also quite a lot of confusion about how much tax you’ll pay on your pension income when you retire.

Some believe there will come a point where the tax relief they are in receipt of now will be wiped out at a later date by a high income tax rate. They think well what’s the point continuing to contribute when that will happen.

And unfortunately they either don’t save as much as they could or they don’t save at all.

Which is a shame because what they believe to be true, isn’t.

I met an individual recently who was 30 years old and he paid little or no attention to his pension.

When I asked him why, he said, what was the point because everyone knows that the government will take all that tax back from you when you reach retirement age.

I asked him, did he think they would tax him at 40% when he reached retirement age?

He said yes, absolutely they would, and he added that it will probably be more, and what’s more all his friends think exactly the same way as he does.

So, what about the future when you’re older, what are you going to live off? I asked.

He shrugged his shoulders, and said he didn’t know but sure what could he do about it?

I thought, God that’s pretty sad and a terrible indictment of the industry I’ve worked in for the past 32 years. How poor have we been at communicating to people like him.

I asked him if he believed me, if I told him that he could accumulate a pension fund of €740,000, take €185,000 from it tax free, and also have an income of about €3,000 per month where he’d pay 0% in income tax?

He said nothing.

I explained to him how this could happen and the figures I was about to show him were based on someone being married, where they take 25% from their fund tax free, and take an income of 4% per year from the balance.

And I was going to include the amount they’d get from the state contributory pension as well and I was assuming they’d get the maximum amount.

You see when you are 66 years or older and married you can earn up to €36,000 and pay zero in income tax.
I showed him the numbers.

- 25% of €740,000 = €185,000, and that’s your tax free amount – do what you want with it.

- 75% of the amount remaining is €555,000 and 4% of this amount is €22,200 pa.

- Add this amount to the state pension i.e. €13,796, and you’d have an income of €35,996

And because it’s under the €36,000 you’d pay 0% in income tax.

So I told the young man I was speaking to that if he personally contributed €325 per month, and his employer matched this amount over 35 years, and his fund returned 5% every year, he’d end up with €740,000.

And here’s the thing, the net cost to him of personally building up the size of this fund would be just €81,900.
The remainder of their fund came from employer contributions and growth achieved on the fund.

And he’d also received tax relief which amounted to €54,600 over that time period as well.

In monetary terms therefore, he’d receive pension tax relief of €54,600, a tax free lump sum of €185,000 and along with the state pension, he’d pay zero in income tax payments each year.

In this example, it obviously makes huge sense for him to put in as much as he could because he knows anything up to or less than a fund of €740,000 he’ll pay no income tax. He was getting tax relief of 40% on the way in and paying 0% on the way out, which is a great deal.

I asked him what he thought of that?

And his reply was, what if my annual income was €50,000? I bet I’d end up with €25,000.

And in fairness to him, in this instance you might think given that amount and the current thresholds, where a married couple with one income begin paying tax at the marginal rate on earnings over €49,000, that they would be hammered with tax at c. 51% but the reality in this instance, is that the effective tax rate would be just 9%.

That figure of 9% is based on (a) the maximum amount paid from the state pension and, (b) having a pension fund of €1,200,000.

Again, very quickly when you take 25% from a fund worth €1.2m, you’d end up with tax free cash of €280,000. The first €200,000 is taxed at 0% and the next €300,000 is at 20%.

The balance is €900,000 and let’s assume you take 4% of it, that amounts to €36,000 and when added to the maximum state pension of €13,796, you’d have a gross income of €49,796, of which you’d end up paying 9% in income tax.

And my point in showing you this very big pension fund size, is to show you how small the income tax paid on it is.

When you run these numbers I hope it puts into perspective just how good the tax break we’re receiving is, and to further quell any misnomer anyone might have about how much tax they’ll end up paying in the future, I’m going to put some pension fund sizes, tax free lump sums and annual income amounts alongside each other, so that you have a reference point as to what rate of tax in retirement you’d pay in each instance.

The numbers I’m going to outline assume:

- you draw down an income of 4% from the value of your pension fund,

- you’re 66 years old and married,

- you’re in receipt of the maximum allowed state contributory pension and,

- you have no other sources of income:

Pension Fund | Size Tax Free Lump Sum |
Net Monthly Income | Income Tax Rate
€200,000     €50,000        €1,632       0%
€400,000     €100,000      €2,116       0%
€500,000     €125,000       €2,354       0%
€900,000     €220,000     €3,150      5%
€1,500,000   €340,000     €52,000   10%

You can see that even with a pension fund of €1.5m, the effective income tax rate is just 10% which is 75% less than what the current marginal tax rate is (40%), and that’s in addition to getting a lump sum of €340,000.

I’m hoping these numbers help, and that people will see the amount of tax they’ll end up paying is nowhere near what they might have instinctively thought it would be, just like that gentleman I met last month. And you know after everything I said and told him, I’m still not sure he believed me.

His lack of knowledge and scepticism was a reason and an excuse for him, to decide not to save much into his pension and not take any interest in it.

And if you are like him, I’m hoping when you see these numbers, they might be the reason why you’ll save more and not less.
And if nothing else, it’s a very smart thing to do. You’re leaving money behind you every year if you don’t, and you’re providing for yourself when you’re older as well, so it really is a win win scenario.

Liam Croke is MD of Harmonics Financial Ltd, based in Plassey. He can be contacted at liam@harmonics.ie or www.harmonics.ie