Tax-exempt growth an often overlooked aspect of pensions

Despite the recent attack on private pensions through the pensions levy, pensions are still the most efficient way to provide for income in retirement.

Most people focus on the tax relief available to pension contributions but overlook the fact that growth within a pension is tax exempt.

Over the longer term, the exemption attributable to this growth can, depending on the investment performance of the fund, be of more benefit than the initial tax relief on the contribution.

We have a poor history of starting a pension early in this country, with most people only rushing to start one once the “finish line” is actually in sight.

However, we need to address the issue that due to our ageing population and other factors, the current level of social welfare payments is not sustainable and the need for supplementary pension income is more important than ever.

We as a nation are facing a pension time bomb — and it’s our younger generation who are likely to suffer the most.

If you don’t start saving for a pension early on in life you may be met with a financially challenging retirement.

The monetary benefits of pension saving in your 20s and early 30s far outweigh the value of 30 years of pension saving in your late 30s, 40s and 50s altogether.

We recently ran a pension savings model which showed that if a person only saved for their pension for 10 years from 25 to 35 and then left the fund to grow with no additional contribution to age 65, the benefit would be greater at 65 than if they had saved for 30 years from 35 to 65. This is the ultimate proof that time is more important than money when it comes to financial planning for your retirement.

As individuals, we need to take command of our own future and in particular of our living standards in our retirement.

How do we do this? Put a long-term savings plan in place. The most tax efficient way of doing that is via a pension, which is nothing more than a long-term savings plan with tax relief. A key attraction is that with current tax rates, for every €100 you save in a pension plan you will get back €41 from the taxman; so that €100 will really only cost you €59 (assuming that you pay at the 41% tax rate).

Depending on whether you are self-employed or an employee, there will be different pension structures available to you.

If you are self-employed (eg a sole trader or a professional) or in non-pensionable employment, you can make contributions to a Personal Pension or a Personal Retirement Savings Account (PRSA) and receive tax relief up to certain limits.

There is no limit on the amount that an individual can contribute, but an earnings cap applies under tax law and as such there are restrictions as to the level of income tax relief that is available on contributions to a personal pension or a PRSA.

The limit ranges from 15% to 40% of net relevant earnings depending on the age of the individual. Relevant Earnings are broadly speaking income from a trade or profession or non-pensionable employment and amounts up to €150,000 can be included for tax relief purposes. For PAYE workers who are members of pension schemes the appropriate pension contract is an AVC. If one isn’t available through your workplace you can always establish your own AVC PRSA.

All tax-payers have the opportunity to pay contributions now and to use this as a deduction for the Income Tax year 2012, and by default reduce their 2012 Income Tax liability.

For example a 40-year-old individual earning a salary of €80,000 in 2012 and who made no personal contributions to a pension in that year can make a maximum payment of 25% of salary i.e. €20,000.

By claiming this against 2012 tax the individual would receive a tax refund of €8,200.

Once you have decided on a pension contribution and what pension type is most suited to you, the final decision is where your money should be invested. Often this decision does not get the attention it deserves.

The problem is compounded by the fact that most people believe all pensions investments are the same. While it is true that the flagship funds of most insurers are all largely similar in make-up, it is definitely not true that all pensions investments are the same.

In general terms it is important to diversify your investment, ie spread it across a range of different asset classes, ensuring you have a number of different investments within each asset class.

For smaller funds this is best achieved using funds.

A cost-effective type of fund can be an exchange traded fund which can, for example, give you exposure to an entire stock market through the purchase of a single exchange traded fund share.

It is important to have a short-term savings plan in place for those necessities which arise during your working life, but it is equally important to take the long-term view.

Your pension effectively is your income in retirement, replacing the salary you earned throughout your working life.

Remember, even though you will be living off a pension after you stop working — any aspiration you have for your retirement will be influenced by how you have prepared for it.

* Aidan McLoughlin is managing director of the Independent Trustee Co

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