Why paying too much into your pension could expose you to a big tax bill

It’s not going to affect too many people. But if you are one of the lucky ones with a pension fund worth close to, or in excess of €2 million, you may well wonder if you’re actually paying too much into your pension. Because you could face an onerous tax come retirement.

You might also wonder why this figure hasn’t changed since it was introduced back in 2014.

What is the standard fund threshold?

Up until 2005, there was no limit on how much people could build up tax efficiently in a pension fund, and be subject to the normal rates of taxation on this income in retirement.

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However, that year the government introduced a standard fund threshold for the first time, at a level of €5 million. According to Minister for Finance Paschal Donohoe, it was designed to prevent over-funding of pensions through tax relieved arrangements. Once a pension fund went over this threshold, anything above the threshold became subject to a "chargeable excess", or additional taxation, of some 40 per cent.

It is possible for someone to retire and still work

The threshold grew each year thereafter on the back of indexation, touching €5.4 million before it was slashed back to €2.3 million in December 2010. From January 1st, 2014, it was cut even further, back down to €2 million.

The new limit did not apply to everyone; pension savers who already had more than €2 million in their fund but less than €2.3 million had an opportunity to apply for a personal fund threshold at that time based on the value of their pensions on that date.

Since then however, the limit has been set at €2 million across the board.

While the legislation does allow that the standard fund threshold and each individual personal fund threshold can increase each year in line with an earnings factor, this increase is at the discretion of the Minister for Finance, and there hasn’t been such an increase since 2008.

Jim Connolly, head of pension and technical services at Goodbody Stockbrokers, says that about 2 per cent of pension savers will hit this target. High ranking public sector workers, such as consultants and judges, are most likely to confront the issue. Others who might hit the limit include very high earners and those who have been very lucky with their investments.

But as Trevor Booth, chief executive of Mercer Financial Services, says, the threshold is not commonly known about – even by those who might cross it.

And while still marginal, a growing number of people are hitting the threshold, as people are working longer, which gives more time for the fund to grow, while investment performance has also been strong of late.

How does it work?

Once you hit the standard fund threshold of €2 million, any income your pension fund generates over this level is subject to a new, additional tax rate of 40 per cent.

As Connolly points out, this means that, at retirement, if your fund stands at €2,001,000, your pension administrator will immediately transfer 40 per cent of this excess, or €400, to the Revenue.

This leaves €600 of the excess, which will then go into your approved retirement fund (ARF). But remember, when you draw down this €600, you'll have to pay a combination of higher rate income tax, USC, and potentially PRSI, depending on your age, on this €600. This means that you could be looking at a combined effective tax rate of 71 per cent on this excess income.

“So you’ll probably end up with about €300 in your pocket,” he says.

One aspect of the standard fund threshold people often aren’t aware of is the impact of divorce. If a couple divorce some years away from retirement, one of the spouses might be entitled to half of a pension – but they may also be subject to half of any chargeable excess the other former spouse might create in the future.

“So you could be faced with a tax bill you don’t know about,” warns Connolly.

What should you do if approaching threshold?

If you are getting close to the €2 million threshold – and remember the threshold operates on an individual basis, so a married couple has a threshold of €4 million – you need to consider what your options should be.

According to Connolly, a key factor to consider is that you’ll only come up against the standard fund threshold once. “What people don’t realise is you’re only ever tested once,” he advises.

This means that one of the simplest solutions, if you’re approaching the €2 million limit, is to withdraw your pension benefits earlier than you might otherwise have planned to. Once it passes the standard fund threshold test at the point of retirement, the fund is then free to grow in an ARF or other structure.

“We try to look for mechanisms to liberate the fund early,” he says, though he adds that this can be “quite difficult”.

If the saver is aged 60 or over, the simplest option is to start drawing down their pension. As Connolly notes, while most people think their employer’s legal age of retirement is the same as that of their pension fund, there is actually no legal link between the two.

So, a person could draw down their pension at the same time as working in full-time employment, as benefits are payable from age 60 in most pension schemes.

“It is possible for someone to retire and still work,” he says.

Where it is more challenging however, is with those aged under 60. If you can’t trigger an early pension liberation, Connolly suggests you consider a stop to accumulating more pension benefits.

Someone with a €2 million pension today will be able to buy less of a pension than they could five years ago

Don't make any additional voluntary contributions (AVCs) to your pension, or accept any employer contributions, because if you took them as salary, you'd only be paying income tax on it.

“There’s probably very little merit in putting in extra contributions if you’re only getting 40 per cent tax relief on it and will pay 70 per cent tax on it when you draw the benefit out,” says Booth.

He notes that if you’re self-employed, you likely should stop making contributions.

If you’re employed however, there are more options, but these need to be considered carefully. Once you leave a employer-based pension plan for example, you could be giving up on extras such as death benefits.

Dialling down investment risk is another approach. “Is it going to be worth having a higher risk strategy if you’ll breach the threshold?” asks Booth, adding that some people with final salary or defined benefit schemes could look at taking a transfer value from their scheme to help them manage the threshold.

Can I get any credit?

While retirees can’t use any other tax credits or allowances to cut the chargeable excess tax, and also cannot offset the tax paid on this charge against any other tax, there is a way of reducing it.

When you reach retirement and take a 25 per cent lump sum for example, only the first €200,000 of this is tax-free. Once you go past this level, you’ll pay tax on the balance at the standard rate of 20 per cent.

So, for example, someone with a €2 million pension pot would get a €500,000 lump-sum at retirement; €200,000 of which is tax-free, and €300,000 of which gives rise to a €60,000 (@20 per cent) tax bill.

And this tax can be used as a credit against any tax owed on the excess. So, for example, in our illustration, our retiree could actually have a pension pot worth €2,150,000, before they would face the 71 per cent tax rate.

There is also another way of having a bigger fund which isn’t subject to the chargeable excess; foreign service. According to Booth, if you spent five years for example, working for the same company in a foreign country, pension contributions accumulated during these years may not be included in the calculation for the threshold figure.

Should it be indexed?

While many people would argue that a €2 million threshold is more than enough, others argue that it needs to grow in line with inflation.

In years gone by, the threshold was indexed – it grew from €5 million in 2006 to €5.165 million in 2007 for example. However, since 2009, indexation has been at the discretion of the Minister for Finance – and successive ministers have opted not to increase it.

Industry association Brokers Ireland, which represents 1,200 brokers across the State, is urging the Minister to consider increasing the threshold in October's budget, which would apply from 2020 onwards, "in line with the growth in average public service earnings".

“The standard fund threshold should therefore move in line with earnings, as otherwise the non-indexation of the limit over time reduces the scope for adequate pension funding,” the association argues, adding that the non-indexation of the standard fund threshold is particularly unfair to those in defined contribution (DC) schemes, because “[defined benefit] DB pensions are considerably undervalued for the purposes of the threshold limit relative to current market conditions”.

Booth agrees, arguing that it would be “reasonable” to increase it in line with inflation, which is up by about 2 per cent since 2014.

“From that perspective, there is an argument there to increase it,” he says, adding that another factor is how annuity costs have increased over the last five years.

Someone with a €2 million pension today will be able to buy less of a pension than they could five years ago.

Connolly however, understands why the Government deems a threshold to be appropriate, and he doesn’t expect it to rise. “I would think in a European context we still look very generous: in the UK it’s at £1 million,” he says.

So it could be that the only way is down from here.

“Our view is that whatever they do, they’re not going to make it any better. So as pension tax legislation, it’s as attractive as it’s ever going to be,” asserts Connolly.