Power up your Pension with Tax Relief & Compounding
Everyone has a bit of an idea of what pensions are but they don’t necessarily understand how brilliant they are.
Rather than take you through the boring details, this article is about the “secret sauce” created by 2 ingredients, tax treatment and time.
- Tax Relief on Contributions
Personal Contributions to a pension plan are treated the same whether you are employed or self-employed. Tax relief is available based on the highest rate of tax you pay, so either 20% or 40%. Add in employer contributions, which are tax-free.
Let’s take a really simplified version for illustration purposes; Prudence, a 30-year-old accountant who earned €70,000 in 2018 and has no pension through work, has made the decision to save €10,000 into a personal pension account throughout the year.
She is entitled to tax relief on 40% of her investment, so the net cost to her is just €6,000. Another way of looking at this is that her €6,000 net contribution is topped up to €10,000, courtesy of the state putting a further 67% into her pension fund.
- Compound This!
Investment gains within pensions are allowed roll up tax free, allowing them to benefit from the investment phenomenon known as compounding. This is where you get interest on your interest. Time is one of the most important factors in this compounding phenomenon.
Let’s go back to dear Prudence and assume she invests her pension in a fund which gives her an annual return of 5%, net of charges, and plans to retire at age 65[1]. The impact of compounding is staggering. At 65, an investment that cost Prudence a net €6,000 has grown to €55,160.
But what if Prudence waited until she was 40? The impact of a 10-year delay is stark. Her final value is now €33,864. Whilst it’s still a very impressive return from a net investment of €6,000, it is 38% less than if she invested at age 30.
Let’s say that Prudence didn’t invest until she was 50. The fund at 65 would be just €20,789. A pretty good return, but the shortened term has meant that the power of compounding is not as pronounced as above.
Long term investments, such as pensions, reward disciplined savers who stick with their investment strategies in good times and bad. This reward comes in the form of compounding returns.
Please note that to get a net return of 5% per annum, you need to invest in a fund with a high allocation to equities. This can result in sharp increases and decreases in value over short periods of time, so it’s not for everybody and you should seek out professional advice first.
At retirement your fund will provide you with a lump sum and your retirement income, which may be liable to income tax, USC & PRSI. Again, you should seek professional advice when considering your options. Ideally you will use a professional advisor throughout your career, but especially as you approach retirement, you need to take advantage of any expertise available to you.
[1] Contract: €10,000 Single Premium 100% allocation, 1% AMC no policy fees, assumed 6% gross growth rate (not guaranteed), estimate only
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