Do pension contributions still make sense?

Irish pension developments
Recent developments have largely been negative. There has been a reduction in pension tax incentives both at the funding and the retirement stage. The key developments are listed below:

• An annual pension levy of 0.6% of the fund value to 2014 (industry speculation suggests it will continue past 2014)
• All individual contributions are now subject to PRSI and the USC
• The maximum salary used to calculate a tax efficient individual contribution has been reduced from €254,000 to €115,000; the table below outlines the age related maximum contributions

• The maximum lifetime tax free lump sum limit has been reduced from €1.35 million (2010) to €200,000
• The maximum lifetime pension fund has been reduced from €5.4 million (2010) to €2.3 million (speculation suggests a further reduction in the next budget)
• The annual Approved Retirement Fund (ARF) drawdown has increased from 0% (2006) to 6%
• The introduction of the USC has impacted ARF holders. The table below outlines the relevant rates.
  Age Income tax PRSI USC Total

Do pension contributions still make sense?
While recent developments do reduce the tax efficiency of pension contributions, there are still some significant positives:

•  Income tax relief is still available at the higher rate of 41% on contributions
•  Investment gains can grow tax free within the pension
•  A Tax Free Lump Sum (TFLS) of 25% of the retirement fund is available at retirement (€200,000 maximum)
• The balance of the retirement fund (after the TFLS has been withdrawn) is unlikely to be subject to the higher rate of tax over the full drawdown period (see above table)
•  There is no obvious tax efficient wealth accumulation alternative to a pension for retirement funding. The table below compares three options for a higher rate tax payer.

*Income tax relief is based on the contribution of €480.

The above table illustrates the net cost of the investment (A) is the same to the individual for each option, (i.e. C - B = A).  However, the total amount the individual actually invests (C), is greater for the pension due to the tax relief enhancement (B).

Case Study –AVC versus Deposit account
A 49 year old employee is considering a discretionary pension contribution or a fixed term deposit.  The individual intends retiring at 65 years of age.  

*Tax rate of 52% assumed for full balance of retirement fund after TFLS

The individual would have to pay an effective rate of tax of 59.9% or higher on the balance of retirement fund (after the TFLS is withdrawn) for the deposit account to be a more tax efficient option.

As highlighted above the combined rate of tax on drawdowns from the balance of the retirement fund is 52% at 65, dropping to 45% from 70 years, therefore the pension option is more tax efficient for this scenario.Please see the assumptions used for the above examples below.