Spotlight

Pensions: the tax rules deciphered

Oct 01, 2018
A comprehensive guide to the tax rules as they apply to pensions in the Republic of Ireland.

BY CRÓNA BRADY

Are pensions really too complicated? Many individuals don’t invest in their retirement and one of the reasons often cited is a lack of understanding when it comes to pensions. This article will outline the tax rules around pensions, consider the tax issues arising when contributing to pension funds, and highlight the tax rules that apply when an individual retires and wants to access their pension fund. 

First, let’s look at the three main types of pension available in Ireland: the contributory and non-contributory State pension; occupational pensions; and private pensions.

The State pension

The contributory State pension is not means-tested and is paid to individuals from the age of 66 who have made sufficient PRSI contributions during their working life. The non-contributory State pension is a payment for individuals who are over 66 years of age, but do not qualify for the contributory State pension because of insufficient PRSI contributions, or who only qualify for a reduced contributory pension based on their social insurance contributions. Both State pensions are subject to PAYE or income tax, but not USC or PRSI. The usual tax credits, including the PAYE credit, apply.

Occupational pensions

Occupational pensions are pension schemes provided by an employer in the workplace. A scheme of this nature is generally funded by both employer and employee through contributions based on a percentage of an employee’s gross salary. For example, an employee might contribute 6% of their gross salary to the occupational pension while an employer will contribute 4%. Tax relief can also be granted to employees on their contributions and this will be discussed in further detail later in this article.

An occupational pension scheme will be either a defined benefit or a defined contribution scheme. In a defined benefit scheme, the pension paid on retirement is related to final salary and the number of years of employed service. The employer will have to fund the pension regardless of the value of the fund at retirement age, hence why these schemes are increasingly rare. Under a defined contribution scheme, the pension payable is based on the value of contributions in the fund at retirement age.

Employers in Ireland are not legally obliged to provide an occupational pension to employees. However, if they do not operate an occupational pension scheme, or have certain restrictions to accessing the scheme, they must by law ensure that employees at least have access to a standard Personal Retirement Savings Account (PRSA).

There are tax benefits available to companies that set up a Revenue-approved occupational pension scheme. For example, the contributions paid by the company will be fully tax deductible for corporation tax purposes provided they do not exceed Revenue limits, which are generous, and the contributions are paid during the accounting period in which the deduction is made. Deductions cannot be taken for accrued pension contributions, while gains arising in Revenue-approved schemes made by the pension fund are exempt from income tax and capital gains tax. Furthermore, any employer’s contribution to the employee’s pension fund will not give rise to a benefit-in-kind (BIK) for the employee.

Private pensions

While an occupational pension is organised by an employer, a private pension is one that is organised by the person themselves. This type of pension is common among the self-employed and workers whose employers do not provide an occupational pension scheme. Private pensions generally take the form of a PRSA or a Retirement Annuity Contract (RAC).

A PRSA is a personal pension plan available to both self-employed and employed individuals who may or may not have an occupational scheme, and is taken out with an authorised PRSA provider. On retirement, a PRSA provides retirement benefits based on the amount of contributions paid and the growth on these contributions. PRSAs are available regardless of your job or employment status so part-time employees, casual workers, contractors and homemakers can take out a PRSA.

An RAC is another form of personal pension plan that can be used to provide a tax-free lump sum and a regular pension on retirement. RACs are available to the self-employed or employees who do not have an occupational pension scheme. The value of the pension pot under the RAC depends on the contributions made and the investment growth. Contributions to both plans are generally made by the individual, although some employers contribute to PRSAs. Where an employer contributes to a PRSA, this is treated as a BIK. Employer contributions to an employee’s PRSA are not liable to USC or PRSI, however.

Tax benefits of occupational and private pension plans

All three types of plan are generally tax-approved by Revenue, which means:
  • You can receive income tax relief on your own contributions;
  • You are not taxable on employer contributions (if any);
  • Your investments roll up tax-free within the pension fund; and
  • The lump sum you can take at retirement is also tax-free up to certain limits.

Tax relief on contributions

Self-employed or individuals in non-pensionable employments can claim tax relief on contributions to Revenue-approved private pensions. Employees can also claim tax relief on contributions to Revenue-approved occupational pension schemes.

Relief is granted up to the highest rate of income tax paid by the taxpayer. If you pay tax at the marginal rate of income tax, relief is therefore granted at 40%. If you are a standard rate taxpayer, relief at the rate of 20% is granted on gross contributions made. There is no PRSI or USC relief available on pension contributions.

The maximum relief that can be granted is based on your age and relevant earnings. If you are 35 and earning €80,000, for example, you can put 20% of your salary (€16,000) into your pension. As you get older, you can save a higher percentage of your annual salary. The percentages are listed in Table 1.

table-1-salary-saved-age

Net relevant earnings are earnings from employment (including BIKs and bonuses), trades and professions less certain payments and deductions and non-pensionable employments. The maximum net relevant earnings for each person that can be taken into account for tax relief is €115,000. This means that earnings over €115,000 will not be taken into account in calculating the allowable pension contribution. Contributions exceeding the limit for a particular year can be carried forward and claimed in the following year, and spouses and civil partners are treated separately. Contributions can also be made until an individual reaches 75 years of age.

An employee who is already a member of their employer’s occupational pension scheme can make Additional Voluntary Contributions (AVCs) to their pension in a given tax year. The maximum tax-deductible contribution an employee can make to their AVC is aggregated with contributions already made to the occupational pension scheme. The above limits for tax relief also apply.

Claiming tax relief

If you are an employee paying PAYE, tax relief is generally applied by your employer via payroll. If not, you can apply online using Revenue’s MyAccount platform. For others, including the self-employed, you can apply for tax relief on contributions through your annual income tax return. Where contributions are made after the end of the year of assessment but before 31 October (or the Revenue Online Service/ROS extended date) of the following year, it may be treated as made in that year once an election is made.

Retirement options

There are several choices when it comes to taking your pension benefits, whether you are in an occupational pension scheme or a personal pension. The options are broadly similar but there are several factors that influence which option is more suitable – not least the size of the retirement fund, the level of income required to fund retirement, other income sources, inheritance planning and current health. Most people will generally choose to take a tax-free lump sum from their pension. The balance of the fund must then be used to either purchase an annuity or investment in an Approved Retirement Fund (ARF). If, however, an individual does not have a pension of at least €12,700 per annum for life or has not reached the age of 75, the lower of €63,500 or the balance of the fund must be transferred to an Approved Minimum Retirement Fund (AMRF) or used to purchase an annuity before an ARF can be purchased.

Tax-free lump sum: the maximum tax-free lump sum that can be taken on retirement is 25% of the value of the fund in the year of payment. This is subject to a lifetime limit of €200,000. Any excess pension lump sum over €200,000 will be subject to income tax with the next €300,000 taxed at 20% and the balance taxed at 48% (40% income tax and 8% USC). If you are a member of an occupational pension scheme, you can take a tax-free lump sum based on your salary and service with the employer up to a maximum of 1.5 times your salary (subject to the overall maximum of €200,000).

ARFs: ARFs are after-retirement investment plans that allow you to continue to invest your pension fund during retirement and draw down money as you need it, rather than buying an annuity.

Annuity: an annuity is a traditional pension policy that guarantees a fixed income throughout your life in retirement. This differs to an ARF, which allows you to draw down different amounts as you need it. Unlike ARFs, when you die, an annuity typically dies with you.

AMRF: an AMRF is similar to an ARF in that any income or gains arising in the fund are tax exempt. However, before investing in an ARF, you must have guaranteed income of over €12,700 per annum including the State pension. If you don’t, then €63,500 of the pension pot must be used to purchase an AMRF or an annuity. The balance of funds can then be invested in an ARF. An individual can only have one AMRF and it becomes an ARF on reaching age 75, or if you satisfy the specified pension income requirement of €12,700 before age 75, or if you die before age 75.

Accessing your pension pot on retirement

On retirement, you will want to gain access to your pension pot. Below, we set out some available options. It is not an exhaustive list, as individual circumstances may differ. All the options discussed below can apply regardless of whether you have a personal pension or an occupational pension plan and crucially, they depend on your level of income on retirement.

Pension fund generates an income greater than €12,700 per year: if you are under 75 years of age and your pension (including the State pension) is more than €12,700 per annum or if you have an existing AMRF with a total premium of €63,500, you can take a tax-free cash lump sum of up to 25% of the value of the pension fund, subject to a maximum of €200,000. Alternatively, those in occupational pension schemes can take an amount based on salary and service up to a maximum of 1.5 times your salary. With the remaining balance, you have four options and must choose one of the following:

  • Buy an annuity, which is a guaranteed pension income for life;
  • Invest in an approved retirement fund (ARF);
  • Draw down taxable cash; or
  • A combination of the above.
If your pension fund generates an income less than €12,700 per year: as noted previously, if you are under 75 years of age and your pension (including the State pension) is less than €12,700 per year, you can still take a 25% tax-free lump sum but you must either purchase an annuity or use the first €63,500 to invest in an AMRF. You can then invest the balance in an ARF or take it as taxed cash. You also have the option to buy extra guaranteed pension income to bring your total up to €12,700 per annum.

Withdrawals and taxation

ARF and PRSA: once retirement age has been reached, you must withdraw a certain percentage from your ARF or PRSA each year under Revenue rules. Every year, Revenue will apply a tax on the assumption that you withdraw a percentage from your ARF and vested PRSA, regardless of whether you do or not. This is known as an imputed distribution. The amount payable is a percentage of the value of your ARF or PRSA fund at 30 November each year. The percentage depends on your age and is 4% if you are 60 years or over for the full tax year, 5% if you are 70 years or over for the full tax year or 6% if you have pension assets of €2 million or more and are over 60 years of age for the full tax year. Any payments from an ARF, AMRF, annuity or PRSA are subject to income tax, PRSI and USC. Tax must also be operated at source by the pension administrator. Tax credits can be allocated against these payments to reduce any tax arising. The income tax rate (20% or 40% before PRSI and USC) depends on the tax rate applicable to you. Pension administrators must apply tax at the marginal rate (40%) unless they have an up-to-date Tax Credit Certificate for the pensioner. PRSI does not apply to withdrawals by individuals over 66 years.

Annuity: payments from an annuity are subject to income tax, PRSI (if under 66 years of age) and USC.

AMRF: an AMRF’s investment growth can be accessed or drawn down before the age of 75. However, individuals can make one withdrawal of up to 4% of the value of the assets of the AMRF each year, which is taxed under normal income tax rules. Any withdrawal taken from an AMRF can be offset against the amount you need to take out of your ARF each year. An AMRF may not be suitable for those who need to take a regular drawdown from a fund before the age of 75. This is why many people choose to take out an ARF with an AMRF, so that the ARF can be used to draw down regular income.

Serious illness: if you suffer bad health and need to retire early as a result, you may be able to take your benefits early. Pension providers will generally seek medical certification from a medical practitioner.

Limits on tax-exempt pension funds: Finance Act 2006 introduced a limit on the value of an individual’s pension fund that qualifies for tax relief. This is called the Standard Fund Threshold and applies to occupational pension schemes, RACs, PRSAs and certain foreign pension schemes. From 1 January 2014, the maximum allowable pension fund (excluding State pensions) on retirement for tax purposes is €2 million. If the fund is greater than this limit, income tax of 40% will be charged on the excess when it is drawn down from the fund.

Conclusion

In Ireland, only 35% of workers in the private sector contribute to a private pension. At the moment, it is estimated that over 600,000 people claim tax relief on pensions in Ireland and the fact that relief is available to everyone – including employees and the self-employed – should act as an incentive in encouraging much-needed pension funding. While tax relief is progressive in that marginal rate taxpayers can claim tax relief at the top rate of income tax, the fact that the relief is a deferral of tax must be kept to the fore in any discussion on pension reform. If measures are introduced to restrict the tax relief currently available to the marginal rate taxpayer for pension funding purposes, or to restrict the tax relief on employer pension contributions, this will discredit any policy measures aimed at encouraging individuals to take responsibility for funding their own income in old age.

Cróna Brady ACA is a Tax Manager at Chartered Accountants Ireland.