Pension holders at a crossroads

What exactly does the Commission on Taxation report mean for pension holders, asks FIONA REDDAN

THE COMMISSION on Taxation report did no favours for middle-income earners when it recommended taxes on child benefit, property and water, so it comes as no surprise that the group’s 14 recommendations on pensions do likewise.

Improving the equitability of pension tax relief while at the same time increasing overall pension coverage is the main thrust of the commission’s pension recommendations, but levelling the playing field for saving incentives will hurt those paying tax at the higher rate.

The commission’s main proposal is that individuals should get a “matching” exchequer contribution, rather than a deduction for tax purposes, to incentivise them to save for retirement in a supplementary pension. What this will mean in practice is that those on lower incomes will find it cheaper to fund their pension, but there will be an erosion in the tax benefits that middle and higher earners enjoy.

If the commission’s proposals are accepted, it will undoubtedly mean significant changes to the way the Government supports contributions to private pensions. But what will it mean for pension holders?

What is “matching”?

At present, pension relief is granted at the rate of tax you pay. Individuals paying tax at the higher rate of 41 per cent stand to benefit most, while those paying tax at the standard rate of 20 per cent only get limited benefit, and those paying no tax get no benefit.

For example, if you contribute €10,000 into your pension each year and are paying tax at the higher rate, you will get relief on this of the order of 49 per cent (contributions are also exempt from PRSI and the health levy), which means that the €10,000 actually only costs you €5,100. So, for every €1 you contribute into your pension, you will get roughly €1 back in tax relief.

For those on lower incomes, who are paying tax at the standard rate, a € 10,000 contribution will cost €7,200, given tax relief at 28 per cent. So, for every €2.50 the individual contributes, the State will give €1 back. The commission deems this system as “regressive”, and in an effort to improve equitability, has instead proposed a “matching” system, whereby pension contributions would qualify for an exchequer contribution of €1 for each €1.60 contributed by the taxpayer, subject to the current age-related and earnings limits.

According to the commission, the benefit of this approach is that it has “the potential to incentivise those on lower levels of income, while still providing those on higher levels of income with reasonably generous support”.

However, this “reasonably generous” contribution could well be insufficient to keep middle to higher income earners incentivised enough to pay into a pension while also failing to attract savings from people on lower incomes struggling to meet existing financial commitments.

How will it affect those paying the higher rate of tax?

At the moment it’s a “no-brainer”, as Jerry Moriarty, director of policy with the Irish Association of Pension Funds (IAPF) sees it, to save for a pension if you can afford to do so, given the level of tax relief available for higher earners.

Under the new proposals, however, instead of the State contributing almost €1 for each €1 contributed by a high rate taxpayer, it would make a matching contribution of €1 for each €1.60 contributed by the taxpayer. This means that for every €100 a higher taxpayer would contribute to their pension, the net cost to them would increase from €51 to €62, so middle and high earners would see an increase in their pension costs of about €11 for every €100. A €10,000 annual pension contribution therefore, would cost €6,200, instead of the €5,100 previously.

Moreover, considering that many pension holders will have to pay tax on their pensions at a rate of over 50 per cent during retirement, the decision to reduce tax relief, or its equivalent under the matching proposals, to 38 per cent for higher earners, will mean that any benefit of saving in a pension has been wiped out. As such, the proposals “could trigger the collapse of private pension provision”, warns Kevin McLoughlin, head of tax services with Ernst Young.

Put simply, if you wished to put €100 in your pension fund, under the matching scheme you would write a cheque for €62 and the Government one for €38.

However, when you go to cash in your fund following your retirement (once you go over the €200,000 tax free limit), you will pay tax on it at the marginal rate of about 54 per cent if you are in that tax bracket. So, despite having put €62 of your own money into the fund, you will only get €46 back, excluding any possible returns the fund may have made. And, given the fact that employees will no longer benefit from tax relief at source, as the state’s contribution will go directly into the pension fund, the changes will also mean that employees will see a reduction in their take home pay.

Nevertheless, despite the reductions in state support for middle to higher earners, Moriarty maintains that if you’re an employee, it will still make sense to contribute to your pension because you will get an employer contribution on top of your own.

Moreover, as Tim O’Rahilly, a tax partner with PwC, points out, employers won’t have to pay employers’ PRSI of 10.75 per cent on pension contributions, which will make it a more attractive method of remunerating employees.

However, O’Rahilly warns that employees will still have to be mindful of the Revenue Commissioner’s rules on “salary sacrifice” when it comes to such actions. For the self-employed, who don’t benefit from employers’ pension contributions, the negative impact of such a move would be greater. As such, they will have to “crunch the numbers”, says Moriarty, before investing in a traditional pension fund, as they might find that alternative investment options will suit them better.

How will it affect those paying tax at standard rate?

If the commission’s proposals are accepted, lower earners can expect to see State support increase significantly on their pension contributions, up from €1 for every €2.50 which they contribute at present, to €1 for every €1.60 they contribute. So, if a standard rate taxpayer contributes €10,000 to their pension annually, the net cost to them under the new proposals would be just €6,200, down from the current level of €7,200. This means that the cost of investing in a pension, up to a certain prescribed limit, for a lower earner would fall by about €10 for every €100 invested.

Why can’t everyone just get relief at the higher rate of tax?

In order to make state pension support more equitable, the obvious solution is to simply give everyone relief at the higher rate of tax.

The commission did examine this possibility and while it saw considerable merit in such an approach, it ultimately took the view that it was too expensive. The most expensive of the possible options, giving everyone tax relief at the higher rate would cost the Government about €750 million a year, due to the potential costs of auto-enrolment.

What does the ARF change mean?

The commission’s recommendation that the flexibility of an Approved Retirement Fund (ARF) should also be extended to defined contribution occupational pension schemes, will change the way some people plan for retirement. At present, members of defined contribution (DC) occupational schemes must buy an annuity, which provides a set annual income, within two years of retirement.

However, given the rising cost of annuities, enabling DC members to purchase an Approved Retirement Funds (ARF) instead would remove problems caused by having to buy an annuity at a time when they are particularly bad value. Moreover, as Moriarty highlights, with people who retire at the age of 60-65 now expected to live another 20 years, allowing DC members to access ARFs will mean those who have the means to do so can keep investing in their pension fund after retirement.

How will the cap on the tax-free lump sum effect me?

The proposal to cap the amount an individual can take as a tax free lump sum at retirement is unlikely to impact on the majority of people.

At present, you can elect to get either 25 per cent of the value of your pension fund or 1.5 times your final salary tax free at retirement. However, the commission is now proposing a cap on this of the order of €200,000, with the balance now subject to tax at the standard rate of income tax. Moriarty doesn’t see it as being “a huge issue” for most people, as you would need to have a final salary of about €133,500 for it to impact.

For higher earners on the other hand, it will have a more negative effect. For example, if you have a final salary of €200,000, you can get a tax free sum of €300,000 at retirement. Under the new regime, however, you will only receive €200,000 tax free, and will have to pay tax at the standard rate on the remainder, bringing your total down to €280,000.

Can I benefit from the SSIA type scheme?

One of the more novel suggestions in the commission’s report is the proposed introduction of a new vehicle for saving for retirement, which would operate in parallel with traditional private pensions.

Aimed at those on lower incomes, this would draw on the success of the Special Savings Incentive Account (SSIA) scheme by offering an easily understood, flexible pensions product. Like the SSIA, whereby the Government contributed €1 for every €4 saved by the individual, under the proposed new scheme, the exchequer would contribute €1 for every €2 contributed by an individual to their pension.

This would mean that low-income earners outside the tax net would still be incentivised to save for retirement.

The scheme would be subject to an annual contribution cap at about €3,300, including the State’s contribution, which would mean those saving in more traditional pensions would not be encouraged to switch.

What does the reduction in standard fund threshold mean?

Following from the reduction in the level of earnings which are eligible for pension tax relief from €275,239 to €150,000 in last year’s budget, the commission has recommended that this move be “accompanied by a corresponding movement in the level of the standard fund threshold”, which is a limit on the capital value of tax relieved pension benefits that an individual can draw down.

The standard fund threshold is currently set at €5.4 million, so if the proposal is accepted, then a corresponding movement would see it reduced by 45 per cent, down to about €3 million. At this level, such a move should not impact the majority of people’s pension funds.

Will the recommendations be implemented?

Launching the report, Minister for Finance Brian Lenihan said the commission’s more complex recommendations are “likely to be phased in over several years”, but it is likely that some of the simpler recommendations, such as the €200,000 cap on the tax-free lump sum at retirement, and the extension of ARFs to DC members, will be implemented this year.

Given that the extension of ARFs to DC members has been a policy issue for quite some time now, Moriarty expects that it will form part of the next Budget.

“I can’t see any reason why it won’t be in the budget, there is no cost element to it,” Moriarty says.

Whether the matching proposals come to fruition or not remains to be seen, as a major barrier to implementing the proposals will be the cost.