What happens if you have too much money in your pension fund?

The pension funding threshold is almost the definition of a first-world problem. What do you do when you have too much money in your pension fund? It is a problem most of us would wish to have but is a real headache for those who do encounter it.

In 2005, the government decided there should be a limit on how much people can accumulate in a pension fund. In theory, this was to prevent high earners from avoiding tax by availing of generous tax reliefs on excessively high pension contributions. It was therefore decided to impose a limit or funding threshold on the size of individuals’ pension pots.

It works by taxing funds that exceed a set limit at the top rate, currently 40 per cent. The neat symmetry there is that the tax saved by the individual is clawed back not only on the original contributions but any growth they may have earned as well. The effective tax rate on pension benefits over the limit is currently about 70 per cent for higher-rate taxpayers.

Reducing tax foregone

The standard fund threshold (SFT) introduced in 2005 was set at €5 million and was to be index linked to allow it increase with inflation. By 2010 the threshold had increased to €5.4 million but the country was in the midst of the Great Financial Crisis and the government was intent on reducing the tax foregone as a result of pension contributions.

That saw a swingeing cut in the SFT to €2.3 million in 2010 and to €2 million in 2014. Those who had already exceeded those limits or indeed the €5.4 million threshold did not suffer from the cuts as they were allowed to apply for a personal fund threshold equal to the total amount already in their fund.

While €2 million might sound like an awful lot of money it would secure a pension of about €70,000 per annum for someone aged 65, without any provision for pension increases at current rates of return from annuities. With inflation at 2 per cent per annum the value of that pension would be reduced to the equivalent of about €47,000 per annum in 20 years’ time.

And it might not take as long as you think for someone to accumulate a pension fund of €2 million. For instance, someone earning €100,000 per annum with a total pension contribution of 20 per cent of salary, the limit would be hit after 30 years, with normal salary progression and investment returns. For someone earning €150,000 per annum with a total pension contribution of 25 per cent of salary, the limit would be hit after 22 years.

In effect SFT is likely to impact anyone earning more than €100,000 per annum and will limit their pension ambition to a maximum of about €70,000 a year.

Inequity

While there may not be a lot of sympathy for people in a position to accumulate such sums, there is growing disquiet in relation to a perceived inequity in the system. That relates to public-service pensions. As things stand, there is no limit to the level of pension which can be accumulated by a civil or public servant and they do not have an SFT to worry about.

This has led ISME, the small-business representative body, to announce a court challenge in relation to the SFT. The organisation announced in September that it was working with members and other interested bodies to take a legal test case against the Government with regard to the way pensions are being taxed in Ireland.

In a statement, ISME claimed that if a secretary-general or a minister retires, their pension could potentially be valued at more than €2.8 million, but it is not taxed in the same way as those working in the private sector.

That case, should it go ahead, could see changes made to the SFT. In the meantime, however, anyone who finds their fund approaching the €2 million mark should start thinking about diverting their pension contributions into other assets.