Pension funding tax breaks are subject to limits. Going over these limits can trigger a penal tax charge. In this article we discuss the maximum you can contribute to your pension, the penalties for exceeding the threshold and strategies to minimise any potential penalties.
Currently you can take private pension benefits funded with the benefit of Irish tax relief to a maximum value of €2m. This is called the Standard Fund Threshold. Any benefits you take in excess of this limit are called ‘chargeable excess’ and are double taxed.
For example, if you matured €100,000 of private pension benefits over the Threshold limit, the first 40% or €40,000 is deducted by your pension provider and paid over to Revenue as ‘chargeable excess tax’. The remaining €60,000 is used to provide taxable retirement benefits for you, typically taxed at top rate income tax and USC of up to 8%.
Therefore, of the €100,000 pension benefits taken in excess of the Threshold limit you might only get as little as €31,200 into your hand after all taxes; a marginal tax rate of about 69% applying in total. This penal rate of tax is designed to discourage people from building up, with the benefit of tax relief, pension funds in excess of the Threshold limit.
How are benefits valued?
For the purposes of the Threshold limit, the cash value of benefits taken at retirement is usually used. For example, if you matured a private pension fund at €1.2m, took €300,000 as a lump sum and transferred €900,000 to an ARF, you would be deemed to have taken benefits of €1.2m value, leaving you with €800,000 of the Threshold for other pension benefits you make take.
For defined benefit pensions, the pension is converted into a notional lump sum by multiplying by a factor set out in legislation:
- For pension accrued before 1st January 2014, the factor is a fixed 20:1 for all ages and types of pensions.
- For pensions accrued after 1st January 2014 the factor varies by your age at retirement, ranging from 37 at age 50 to 22 at age 70.
For example, a pension of €50,000 pa, of which €40,000 was accrued by 1st January 2014, would be valued at a notional 20 x €40,000 + 26 x €10,000 or €1,060,000 for the purposes of the Threshold limit if you retired at age 65.
Personal Fund Threshold
The Threshold limit was originally introduced in 2005; first at €5m, then indexed up to a high of €5.4m in 2008, before being reduced in phases to its current €2m.
At each reduction individuals who held at that stage private pension benefits in excess of the reduced Standard Fund Threshold were able to claim a higher Personal Fund Threshold to protect accrued benefits from a future chargeable excess tax charge.
Going over the Threshold limit
If you end up taking pension benefits in excess of the Threshold limit and a chargeable excess tax charge arises, you can reduce this tax charge by offsetting any standard rate income tax you have paid on pension lump sums taken since January 2011.
Currently the first €200,000 in total of all pension lump sums taken since December 2005 are tax free, with the next €300,000 subject to standard rate income tax.
The chargeable excess tax will be taken by your pension provider from the gross value of benefits you take over the Threshold, unless you reimburse the provider from personal funds (highly unlikely).
If you take a public service pension giving rise to a chargeable excess tax charge, you can opt to pay the chargeable excess tax arising in yearly instalments over 20 years by an annual reduction in your gross pension. The big advantage of this approach is that if you die within the 20 years period, the balance of the chargeable excess tax is written off.
This is a particularly useful option for judges and HSE Consultants who typically have a mix of private and public service pension benefits. By ensuring their public service benefits are taken last, they can opt to pay the chargeable excess tax arising on the drip over 20 years in retirement, with no interest added and the balance written off on death within this 20 year period.
For clients who can control the pace at which they are funding their pensions, e.g. the self employed and proprietary directors, it is important to project ahead and suspend funding if future funding and anticipated investment growth will carry you over the Threshold limit by the time you take your benefits.
Where your fund is close to the Threshold limit, you could consider adopting a conservative investment approach in order to try and freeze its value. While you will always get at least 30% of any excess over the Threshold limit, the problem is that the risk/reward mix is out of kilter, when you are close to the Threshold limit.
For example, if your fund is just at the Threshold limit and you adopt a high risk investment approach which pays off, the Exchequer gets 70% of your gains and you only get 30%. But if your high risk investment approach goes wrong and you suffer a loss, the Exchequer suffers, say, 48% of the loss (the tax it would have got on your lost fund) but you lose 52%.
So if you are just at the Threshold limit, you only get about 30% of any upside but will suffer 48% of any downside in investment performance. This imbalance in risk and reward explains why many at or near the Threshold limit decide to ‘freeze’ their fund value through a conservative investment approach.
It is important to plan in advance if you are likely to accumulate significant private pension benefits and monitor your pension trajectory towards the Threshold limit. Future investment growth and funding could carry you over the Threshold limit with a penal tax charge of 69% on the excess over the limit.
Author: Brendan Reade, Director/Owner, Signature Financial Planning Ltd. www.signaturefinancial.ie
Disclaimer: The content of this article is for general information purposes only. It does not constitute investment advice as it does not take into account the investment objectives, knowledge and experience or financial situation of any particular person or persons. You are advised to obtain professional advice suitable to your own individual circumstances. Signature Financial Planning Limited makes no representations as to the accuracy, validity or completeness of the information contained herein and will not be held liable for any errors or omissions. Signature Financial Planning Ltd T/A Signature Financial is regulated by the Central Bank of Ireland