The pension’s landscape has significantly altered with changes to the tax relief afforded to pensions announced during Budget 2011 (7 December 2010) and confirmed in Finance Act 2011. These changes will potentially impact anyone that is providing for their personal pension, as well as employers, and therefore requires immediate attention. There is no doubt that these changes will alter the way many people (both employees and self employed) plan for their retirement as there are now significant limits on the level of tax efficient pension funding that is possible. Employers providing pension benefits to their employees will also be impacted and must re-evaluate how they reward people.
The breadth of these changes cannot be underestimated as they impact tax relief on pension contributions, the amount which can be accumulated in a pension on which tax relief is available, and also the tax charged on pensions on retirement. We highlight below some of the main points which may concern companies, their employees and also self employed individuals, all of which require immediate consideration. Also, with another budget on the way possible further changes in the pension’s area, it is critical to evaluate your options now and plan for retirement. We also include in Appendix One a high level summary of the other principal changes to pensions which were introduced by Finance Act, 2011.
Standard Fund Threshold (“SFT”) –Individual Pension Funds
Prior to 7 December 2010 a tax charge was imposed at retirement on the excess value of a pension fund over €5.4m (or such higher amount as agreed with the Irish Revenue Commissioners). This value is referred to as the SFT or Personal Fund Threshold (see below). From 7 December 2010 this threshold has been reduced to €2.3m (subject to some grandfathering – discussed below). Therefore, the value of a pension fund over and above €2.3m on retirement will be liable to tax at 41%. When the net after tax excess is drawn down (e.g. pension is paid out to the individual), it is taxed as income in the individual’s hands at up to 48% (marginal rate income tax of 41% and the Universal Social Charge “USC” of a maximum of 7%). This can result in a combined effective tax rate of 69% as set out below:
Valuation of Pension Funds
For individuals in a defined contribution scheme, the value of the fund at 7 December 2010 is the market value of the net assets in the fund at that date. For individuals in a defined benefit scheme the value is calculated by multiplying the accrued pension (as if they were to retire on 7 December 2010) by a factor of 20. This means that those individuals who would be entitled to a pension of more than €115,000 (e.g. a salary of €172,500 at retirement x 2/3rds) if they retired on 7 December 2010 will exceed the new €2.3m threshold.
Grandfathering Rules
It was possible for individuals whose pension fund value at 7 December 2010 exceeded €2.3m to apply for a threshold amount of up to €5.4m by 7 June 2011. An application had to be made to the Irish Revenue Commissioners requesting such a Personal Fund Threshold (“PFT”). If an individual already had a PFT in excess of €5.4m (based on Revenue approval following the changes brought in by Finance Act 2006) then no action was required. An individual whose pension fund was lower than €2.3m in value on 7 December 2010 could not apply to obtain a PFT in excess of €2.3m (even though the SFT of €2.3m may be exceeded in the future based on forecasted pension contributions and values).
Action
- Clearly it is not efficient to continue funding a pension after the SFT of €2.3m (or higher PFT where appropriate) has been reached and alternative forms of retirement planning should be considered. This will generally necessitate actuarial input to assess the ‘value’ of pension benefits and the impact of restructuring and other alternatives both for the employer and individual as appropriate
- Employers should communicate with employees in order to ensure that employees are aware of the changes introduced as soon as possible
- Employers should consider putting a tracking system in place for their own purposes but more importantly for employees to determine when an individual’s pension fund may be coming close to the SFT so that alternatives can be considered in advance
- Individuals whose pension fund is currently less than €2.3m should consider funding their pension to €2.3m (taking account of a buffer for future investment returns within the fund up to retirement) in light of announcements to decrease tax relief on pension contributions and other potential changes that may be introduced in the forthcoming budget. We also include in Appendix Two a high level summary of some of the key points and an action list to consider in the context the SFT/PFT.
Tax Free Lump sum on retirement
Another significant change to the taxation of pension benefits is that the maximum tax free lump sum which can be obtained has been reduced from €1.35m to €200,000 for payments made on or after 1 January 2011 (which is a cumulative lifetime limit). Any tax free lump sums taken since 7 December 2005 are aggregated also in determining whether the €200,000 threshold has been exceeded.
The excess pension lump sum will be taxed as follows: Therefore the first €575,000 lump sum on retirement can be obtained at a tax cost of €75,000 (representing a 13% effective tax rate). However, if €1.35m (which was the previous maximum that could be paid tax free) was
due then the tax cost would be €447,000, representing a 33% effective tax rate as compared with no tax cost being applied on such a lump sum up to 31 December 2010.
Action
Therefore, while availing of a lump sum upfront will remain an important part of retirement planning, individuals will need to consider alternative ways of providing for their future to ensure that they have sufficient after tax funds available up to and after retirement.
Appendix 1 - Summary of other changes to the taxation of pensions
Appendix 2 - Pension SFT/PFT action list
