Recently, you will have become very familiar with radio ads from Revenue advising you that the tax deadline was approaching for self assessed tax payers and that failure to comply would result in punitive penalties and surcharges. Ouch!
The perennial response of many in the self-employed ranks was to try and mitigate tax by making their annual pension contribution (it affects more than just self-employed but, for the purposes of this article, I will restrict comments to this cohort).
And, when we meet with them and initially ask them about what have they done in relation to pension planning, why they’ve done it, and if they understand the ‘end game’ options now available to them at retirement, we are invariably met with “Wha’?” Astonishing stuff!
Now we know that Retirement or Pension planning is not at the summit of everyone’s most favoured activities, but being able to control your own destiny, minimising stress and hardship in old age and having the financial wherewithal to afford to do the things which are very desirable are undoubtedly on most individual’s wish list.
So ignoring retirement/pension planning just isn’t practical unless you are hoping that by some miracle you are expecting a lottery win or to be left a fortune by the little old lady you once helped cross the street! And yet, the ignorance, apathy and inertia are staggering.
So how do we change that?
Well, I’ve decided to set out 7 questions which, if you can’t answer – or if you are entirely vague in your responses – just might make you sit up and take some action… and talk to us of course!
1. Why should I have a Pension Plan?
The simplest answer is: “Can you afford not to?” Thankfully, the government encourages pension funding and, with tax relief on contributions still pegged at up to 40%, there is a significant incentive to fund a pension – especially if you are a top rate tax payer.
My colleague, Andrew Fahy, very aptly describes this as an “interest free loan from the government for the duration of your working life’.
Clearly, the ultimate objective is to create a fund of sufficient magnitude to allow for a comfortable retirement which is comparable to the standard of living the individual had enjoyed through his/her working life. Given the generous tax breaks, the compounding effect on these and the underlying investments which populate your pension fund, this is a terrific way of saving for the future when you don’t want to work or can’t work. That makes sense!
2. Where is it invested?
Anecdotally, most clients we meet haven’t a clue how to answer this question. They typically write a cheque annually to a domestic life assurance company without any idea of where their hard-earned money is being invested. They do this without any cognisance of the risks they may be taking or where it is most appropriate to invest and allocate their contribution.
This inertia doesn’t just happen once – it recurs year after year. Mis-allocating your pension contributions can result in significant differences between the fund you end up with and the fund you should have ended up with.
Writing a cheque to reduce tax is one component of the planning process. Hiring a competent and well-resourced investment adviser who can understand your objectives/risk profile and circumstances and who can also interpret and invest appropriately across various asset classes is VITAL!
If you don’t know where your funds are invested, there are names I could call you… but I won’t. I’m too polite.
Bear in mind too that investing through a pension is highly tax-efficient. Pension plans are ‘tax-exempt’ so no taxes are paid on income/gains within the structure and the benefit of compounding these returns means that this form of investing has no equal.
3. How much can I invest?
For self-employed individuals, this is age-related and subject to an earnings cap of €115,000.
So, a 42 year old can invest 25% of €115,000 but a 52 year old has slightly greater latitude and can invest 30% of €115,000. These are the limits for tax relief.
In aggregate, the current Standard Fund Threshold (SFT) is €2m. This is the total value of all retirement benefits which can be taken by an individual. Amounts over this figure are subject to a highly punitive “excess” tax of 70%.
Contributions can differ between self-employed and employed (in company schemes) with greater scope available in company arrangements where overall contributions often include both Employer and Employee inputs.
4. How much am I being charged?
This is a very interesting question!
Regulations applying to intermediaries and pension salespersons dictate that fees/commissions are fully disclosed. It is of critical importance that an investor is fully aware of the charges that apply to their investments, what commission has been paid to the salesperson and, importantly, what restrictions apply if you decide to transfer to another provider or investment manager.
Now I’ve no qualms about advisers being paid; we all rely on that. But know what you are paying for, what on-going services you can expect (especially on how and where you are invested), and don’t get ripped off!
5. When can I retire?
Usually from age 60 for self-employed individuals but earlier if due to ill health, and you can continue to contribute until you are 75 if you wish and so long as you have a source of relevant earnings.
And, in a world where we are all living longer, if you retire at 60, you may live a further 25 years. Can you afford to do that?
6. What happens when I retire?
This is the interesting bit! You have worked and saved and now you want to draw on your hard-earned savings.
For private/personal pensions there is an option to take up to 25% of your accumulated fund as a lump sum. Historically, this was all tax-free. This has now been restricted to €200,000. Any lump sum above this and less than €500,000 is subject to tax at 20%.
With the balance of your fund, you can either:
a) Buy a pension/annuity
– These are very expensive due to the prevailing low interest rate environment (annuities are backed by government bonds which are at historically low yields) and because we are all living longer.
– However, an annuity does provide for a secure and known income for life.
b) Invest the balance in an Approved Minimum Retirement Fund/Approved Retirement Fund (AMRF/ARF).
– This option means you retain the accumulated capital into post-retirement. Monies are invested and mandatory taxable drawdowns are made annually.
– AMRF/ARF assets can be passed tax-free to a surviving spouse on death and subsequently to children (as cash) with tax consequences.
– However, the AMRF/ARF essentially becomes an asset and part of your own family balance sheet.
– Fixed income is swapped for variable returns which are often market-dependent (mortality risk is replaced by investment risk)
c) Cash in the balance but pay income tax/USC/PRSI (and this is subject to certain conditions)
So, potentially, your pension pot can develop into one of the most significant assets you will ever accumulate.
7. What happens if/when you die?
Sorry to end on a slightly downbeat note, but we’ll all die sometime and we need to understand the financial consequences!
If you die before drawing your pension benefits (personal pension/PRSA), the entire proceeds can pass tax-free to a surviving spouse, and that at least is some comfort.
Different rules apply to company arrangements. If you die post-retirement, having purchased a pension/annuity, it depends on the terms of the annuity and whether or not a surviving spouse is provided for. Otherwise, the fund you used to buy the pension can evaporate.
If you die post-retirement, having set up an ARF, this structure can pass tax-free to a surviving spouse as an ARF. For others, like children, tax consequences apply so advice is required.
It makes sense to conduct your own due diligence and pension audit to see if you are ensuring that your retirement wish list isn’t being undermined by yourself or by others.
Joe Hanrahan, Investec Wealth & Investment.