Some say it's overly generous. Others say it's essential as a means of incentivising people to set aside money for their retirement. With calls to restrict how much pension savers can withdraw tax free at retirement, has the time come to cut the pension lump sum?
What is it?
When you retire, you are typically able to withdraw a certain portion of your pension fund, tax free, up to a limit of €200,000. This is a total lifetime limit, even if lump sums are taken at different times and from different pension arrangements.
Lump sums in excess of this are subject to tax, but at a lower rate. Lump sums between €200,001 and €500,000 for example, are taxed at 20 per cent, with any balance over this amount taxed at your marginal rate and subject to both PRSI and the universal social charge.
For retirement annuity contracts (RACs), Personal Retirement Savings Accounts (PRSAs) and for people transferring to approved minimum retirement funds (AMRFs)/approved retirement funds (ARFs) at retirement, the lump sum limit is 25 per cent of the retirement fund.
When it comes to defined benefit occupational schemes however, a different multiple applies – up to 1.5 times your final remuneration as a lump sum if you have completed 20 years’ service and have no benefits from a previous scheme.
So, for example, if your pension fund is worth €100,000 and you’re putting it into an ARF, you could take out €25,000 upfront and tax free; if it’s worth €1 million, you could withdraw €200,000, as the drawdown is capped at €200,000.
On the other hand, if you're the beneficiary of a defined benefit scheme, and your final salary is €80,000, then you may get a lump sum of €120,000.
Why change it?
In short, some have argued that the lump sum should be reduced as it is too generous, is inequitable – as those who have larger pensions benefit to a greater degree – and it is costing the exchequer too much in lost tax at a time when pressure to generate revenue to fund public spending is expected to rise.
In a report earlier this year, the Economic and Social Research Institute argued that “substantial revenue” could be raised by restricting the size of the lump sum, arguing that it is poorly targeted for lower to middle earners as it provides a much larger bonus for higher rate income tax payers in retirement than for basic-rate payers.
Speaking at an Oireachtas committee on budgetary oversight in June, ESRI economist Barra Roantree said additional sources of revenue would be needed going forward, given that "there will be a need for tax increases in coming years" due to planned spending increases.
And limiting the retirement tax free lump sum could be one such source.
Figures from Revenue for 2014 show that it cost the exchequer more than €130 million a year in taxes forgone.
Many argue that the lump sum is vital in encouraging people to save for their retirement
Also speaking at that committee meeting, Micheál Collins, assistant professor at the School of Social Policy, Social Work and Social Justice at University College Dublin, said the relief was pitched at an "abnormally high level in international contexts", noting that many countries do not facilitate any tax-free drawdown.
And then we get back to the fact that it favours those who are more well-off. “The benefit is much greater to those with the highest incomes and the largest pensions savings,” said Collins.
For example, someone paying tax at the standard rate throughout their life, may build up a modest enough pension fund, and will therefore be entitled to a modest enough lump sum – €40,000 say, on a pension fund worth €160,000.
By comparison, a higher rate taxpayer will have enjoyed double the tax relief on the way into the fund, which they have managed to grow to €800,000, and will then benefit again from a €200,000 lump sum on retirement.
It’s a significant difference.
Roantree agrees that the lump sum is “a very poorly targeted form of tax relief” and benefits those who have been on high earnings throughout their careers.
“I would not be particularly worried about anyone who might be affected by reducing that from €200,000 to, for example, €100,000 being at risk of having inadequate income in retirement. These are people near the very top of the income distribution, both in retirement and through their working lives.”
Collins also suggests reducing the lump sum to improve equitability. “It is not about taking anything away from people but about making the system fairer and limiting the exposure of the State to some of the costs,” said Collins, noting that a value set at two-thirds of average earnings would correspond to about €30,000.
Why it should be kept
Many, however, argue that the lump sum is vital in encouraging people to save for their retirement. John Tuohy, chief executive of pensions adviser Acuvest, can understand the argument in favour of cutting the lump sum, given the impending pressure on spending.
However, he wonders whether cutting it, which would save the exchequer potentially somewhere north of €134 million, would be a worthwhile effort.
“There’s much bigger fish to fry in terms of revenue-raising measures,” he notes. Indeed, according to the aforementioned ESRI report, removing the capital gains tax relief on family homes for example, would generate about €2.4 billion, while Capital Acquisitions Tax Business Relief costs the exchequer €200 million a year, and increasing the standard rate of VAT would generate €440 million a year.
By comparison, he argues that the amount generated by cutting the lump sum relief would be too small to warrant the upset it would cause pension savers.
“Everyone benefits from this. I don’t think you’d meet a person around the country who would be enamoured with it changing,” he says, adding that people will use the tax-free lump sum to pay down debt, add to their savings, or fund travel abroad.
Given an ageing population, he argues, encouraging people to save for their retirement is too important to meddle with.
“For that, we need good incentives and we need certainty. I’d be cautious about changing the goalposts on people,” he says, adding that such a move could be “counter productive”, as it could stop people saving, “and we’re already struggling to get people to save enough into pensions”.
He also points to the reduction in the standard fund threshold, which is the amount savers can build up in a retirement fund without being subject to severe tax penalties, back in 2005, as evidence of a move by Government to make the pensions system fairer.
At the time, the threshold was cut from €5 million back to €2 million.
The ESRI report also suggests reducing this limit still further, noting that it primarily affects those with very large pension pots.
There is also the issue of offering a lower rate of tax on lump sums in excess of €200,000, with a rate of 20 per cent levied on amounts of up to €500,000, significantly less than the marginal rate plus PRSI which would otherwise apply.
The greater the lump sum a saver takes, the bigger reduction to the fund that has to sustain them for as many as 30 years, or more
It means for example, that a lump sum of €350,000 will have tax payable of just €30,000, something which could be queried as, again, it favours those with larger pensions.
For Tuohy however, offering this incentive means “that the government gets a share of the pie faster”, noting that if this money wasn’t withdrawn, it would just sit there, and the Government wouldn’t get any tax revenue until it was withdrawn at a later stage.
Withdrawing pension savings
A further concern with the lump sum is that it encourages the withdrawal of large sums from retirement savings, when the purpose of offering pension incentives is to allow savers generate a regular stream of income in retirement.
The greater the lump sum a saver takes, the bigger reduction to the fund that has to sustain them for as many as 30 years, or more.
As such, the ESRI has suggested that alternative subsidies to the lump sum could be considered, which may better target lower and middle earners. These could include higher personal tax credits for those over the State pension age, or a top-up to pension funds if and when the fund is annuitised.
This option could work a little like the SSIA scheme of 2001, where contributions would be initially subsidised at a generous rate, and these subsidies capped at a maximum cash amount per person to effectively target those with smaller pension pots.
For Tuohy however, this again goes back to the appeal of pensions in the first place, and the incentives needed to get people to save and the dangers of changing it and removing this certainty.
“If you want people to save for private pensions, you need to incentivise them. We’re going to give you tax break on the way in, then on way out we will give you a [tax free] lump sum, and then there will be income tax on everything after that. That’s what it is, that’s the proposition.”
