When you hear talk about pensions, it is inevitably about whether people will have enough in retirement. Too few people are saving into pension schemes and, of those who are, too few of them are putting enough into those savings. That’s why the Government is setting up a mandatory workplace pension scheme – auto-enrolment – for anyone between the ages of 23 and 60 who is earning in excess of €20,000.
Well, they’re not actually; they’re still talking about it as successive governments have been for the past quarter century. But on their latest timeline, auto-enrolment will be with us in the second half of next year. Personally, I wouldn’t bet on that but we’ll see what happens.
Against that backdrop, it seems a little counterintuitive to ask whether it is actually possible to have a pension fund that is too big but, as recent reports about senior gardaí shunning a recruitment campaign for a deputy commissioner post showed, it is. And getting your sums wrong on this can prove expensive.
So how much do you have to save before you’re at risk of having a pension fund that is too big? What happens to you if you cross that threshold? And if, for any reason, you are getting close to it, are there any steps you can take to stay the right side of the threshold.
The key factors here are the generous tax relief given on pension contributions and something called the Standard Fund Threshold – yes, it’s one of those pension-speak words that all too often make people think it’s all too complicated and they are better tuning out. But the Standard Fund Threshold is simply the upper limit on the size of a pension fund that can qualify for tax relief.
If you have availed of tax relief – as would be standard – on contributions to your pension fund, and that fund tops the Standard Fund Threshold by the time you retire, Revenue simply takes the benefit of that back from you when you start drawing down your pension – at least till your fund falls back under the threshold.
At the moment, the threshold is €2 million. When it was first introduced bank in 2005, the figure was a more generous €5 million. That was indexed and rose to €5.4 million in 2010 before being cut that year to €2.3 million and then to €2 million in 2014.
If, on the date, you start to draw down the pension, you have more than €2 million in the pot, anything above that ceiling is subject to an upfront income tax charge of 40 per cent in that tax year – effectively clawing back the tax relief originally given. You will also be charged normal income tax (and universal social charge) on anything you actually draw down from the fund in that same year. That means anything above €2 million is essentially subject to 70 per cent taxation.
As with so many of these things, the catalyst for introducing the threshold was concerns about tax avoidance – the perfectly legal use of loopholes to game the tax system, as opposed to tax evasion. Essentially, a relatively small number of extremely wealthy individuals were using the 40 per cent tax relief on pension contributions as a broader tax efficient investment tool rather than for pension purposes.
Hitting the ceiling
Measuring the size of your pension pot is straightforward if you are in a defined contribution pension. You make your contributions and are updated regularly about how the investment return has performed and the current size of your pot.
But what about defined benefit pension schemes? There it gets trickier. These are generally paid as a percentage of your final salary. That is changing somewhat but we’ll use it for now. The legislation says you multiply the expected annual pension before any lump sums and multiply it by a number that relates to your age at the time you start taking the pension.
So let’s say your final salary is €120,000 and you are entitled to a pension equal to two-thirds of that – €80,000. You are retiring at 66, so the multiple is 25. That brings you right up to the €2 million threshold – 25 x 80,000 = €2m.
As you can see from the figures – the average defined contribution pension pot these days is in or around €100,000 – this will not be an issue for everyone. But for those in high-paying professional roles or, as we have discovered with the Garda case, at senior levels in public service, it presents a headache.
A large part of that is the failure to index the threshold from 2014. Wages have risen in the meantime – quite dramatically for certain groups. The Government has announced a review of the threshold as part of its efforts to fill the vacant senior Garda post and it seems likely to feature some form of indexing to restore the threshold at least to its 2014 level in real wage terms.
Options available
But meantime, what can you do if your pension pot is above the threshold or heading that way?
The most obvious options is to stop paying into the fund. Sure you will be missing out on tax relief on entry but that relief will be more than offset by any 40 per cent charge on the excess at maturity and the 40 per cent at that stage will include a charge on the investment return so there’s no benefit to continuing to invest in the fund.
Another option is to slow down any investment return in the fund. As you get closer to retirement age, risk profiling will move in this direction anyway as you are less able to recover from the sort of volatile fall that can occur with higher risk assets, but you can further downgrade the risk profile – by investing more of the fund in cash, for instance, to try to stop it breaking past the €2 million barrier.
Taking a lump sum is standard practice on retirement. Revenue rules allow you to take up to 25 per cent of your fund as a lump sum – although anything above €200,000 will be taxed, but only at the standard income tax rate of 20 per cent. If you have a €2.4 million fund, 25 per cent would be €600,000. Tax on the €400,000 above the tax free limit would come to €80,000 and the good news is that you can offset any tax due for being over the €2 million ceiling against this.
For those in some occupational schemes, you might have the option of moving some of your pension assets to a fund in another EU state where the rules might be more generous. The Irish cap relates only to pension funds held here.
Finally, you could take your benefits earlier. You can generally draw down pension benefits from the age of 50 in most schemes. If the fund looks like it is heading for the limit, such a move would stop the clock, although your fund will now need to cover a longer retirement period.
Alternatively, you can simply hope the Government review will raise the threshold. It might well do this but you are clearly taking a risk, not least as it is difficult to say exactly to what extent any loosening of the rules will amount to.
You can contact us at OnTheMoney@irishtimes.com with personal finance questions you would like to see us address. If you missed last week’s newsletter, you can read it here.
