Pensions: When enough can be too much

Pensions are a highly tax-efficient means of saving for your retirement. One of the biggest advantages they offer over other forms of saving is the generous tax relief you get on contributions.

Unfortunately, it seems you can get too much of a good thing. Individuals saving for retirement face a limit on the amount they can contribute under these terms.

Called the standard fund threshold (SFT), it stands at €2 million. Any contributions above that are hit by a punitive tax. If you have reached that point, or are fast approaching it, there are some serious decisions to be made.

But first, take a second. "The first thing to say to anyone who has reached this threshold is congratulations," says Brian Kingston, retirement and financial planning manager at Brewin Dolphin Ireland.

“It means they’ve done an awful lot of good things in their life, like having sacrificed income in employment for income in retirement and taken an investment risk over time.”

What happens next will depend on each individual’s situation.

“We come across people with €2 million pots on a daily basis. With each client, we try and build out a retirement number based on what they need to reach to replace income in retirement through pensions and savings,” says Fergal Roche, pensions financial planning manager at Davy.

Lump sums

Typically a person will take their maximum entitlement of a 25 per cent lump sum out of that that €2 million. The first €200,000 of that €2 million is tax free. Lump sums of between €200,000 and €500,000 are taxed at 20 per cent, with any balance over this amount taxed at your marginal rate and subject to the universal social charge.

The amount of lump sum you can take out of a pension arrangement depends on the type of arrangement you have. For personal pensions, personal retirement savings account (PRSAs) and people transferring to AMRF/ARFs (approved retirement funds) at retirement, the lump sum limit is 25 per cent of the retirement fund.

For a defined-benefit occupational pension scheme you may be able to take 1.5 times your final remuneration as a lump sum, once you have completed 20 years’ service and have no benefits from a previous scheme.

For a defined contribution scheme, the amount of lump sum available to you depends on whether you choose to take your benefits in the form of an annuity or an AMRF/ARF.

Anyone looking to take a €500,000 tax-free lump sum will get €440,000 in cash, leaving them with €1.5 million with which to buy a pension.

It’s worth noting that the €60,000 paid in tax above is actually a credit which you can offset, meaning you can actually fund to €150,000 above the threshold, effectively taking it to €2.15 million.

But when the STF was first introduced, in 2005, it was €5 million, a figure indexed to inflation. By 2011 it had hit €5.4 million. Since then it has more than halved however, to €2 million. The biggest cut took place during the Great Recession, in 2010, but business lobby group Isme is actively campaigning to see it restored, on the basis that as it currently stands it puts private-sector workers at a disadvantage to public-sector counterparts.

Even leaving that aside, while a €440,000 lump sum seems like a lot – and indeed it really is – very many people use it to pay off debts, to build core reserves for their own peace of mind and to help the kids, particularly in relation to housing deposits right now.

And while it has been maintained at €2 million since 2014 in nominal terms, in real terms its value has been falling, while costs such as nursing homes, home help and health insurance have all gone up.

Investment risk

On top of that, while public-sector pensions are guaranteed, low interest rates mean buying an annuity income is simply not an option for private-sector pension potholders. Instead they put their money in an ARF, which means private-sector pension holders must carry that investment risk for the rest of their days.

Despite all this, if they go above the €2 million barrier, contributions are taxed at 40 per cent, and taxed a second time when they draw it down as income. It amounts to tax of about 70 per cent on contributions that breach the threshold.

To avoid this, those funding retirement savings need to take stock of where they are in relation to the threshold. “We build out plans for people over time, monitoring them 10 and five years out, perhaps slowing down contribution rates,” explains Roche.

“If it doesn’t make sense to continue we will look at switching off contributions and look at investment strategies. Where it makes sense to we might slow down risk and put some in cash.”

In some cases a phased retirement strategy will be most appropriate, such as where a person has multiple deferred pension pots accumulated over a long career.

It may make sense to convert them into a PRSA, which they then split in two. “If you have €3 million in total, you could put €2 million into one PRSA, and €1 million into the second PRSA, and leave the second one to be drawn down at age 75, thereby deferring the tax,” explains Roche.

“It creates an insurance policy in so far as, if you die before age 75, you don’t have to pay tax on it and the full value of your PRSA goes to your estate.”

As with pension planning generally, for optimum results in relation to the SFT, the earlier you start managing it the better.