Accessing Pension Benefits at Retirement
Any individual can retire from age 60, assuming they are in a strong enough financial position to do so.
At this stage you will have a Personal or Company Pension Fund which has been built up over a long number of years. One of the most important financial decisions any investor will make in their lifetime is how to draw down this accumulated pension benefit when they retire. The options are complicated, and there are a bewildering range of products to choose from. In this summary below I will attempt to explain a number of the options available.
The Tax Free Lump Sum
Firstly, everyone is allowed to take a portion of their fund as a Tax Free Lump Sums (TFLS), however exactly how this Lump sum is calculated may vary depending on your personal circumstances and the size of your pension fund. For example, if an employee has more than 20 years service they have the option to take 1.5 Times their Salary as a tax free lump sum, assuming they have enough in their fund. This can be a very efficient way to take pension benefits, particularly if the fund is relatively small and close to the 1.5 Times Salary amount.
The alternative means to calculate a Tax Free Lump Sum option is 25% of the fund value. This is the more common option particularly for larger funds, however some limits do apply. The “tax free” element of the lump sum is limited to €200,000. The next €375,000 is taxed at 20% so the total limit is €575,000.
Once tax free cash has been taken from the fund, the next decision is how to draw down the remaining funds. This is the more complicated part and depends on a number of factors. The main options are as follows:
You pay over the remaining funds to a life assurance company and they promise to pay you a pre-agreed annual income for life. This pre-agreed amount can include a wide variety of additional options, such as a ‘spouse’ annuity, annual increases and guaranteed payment periods. The main advantage of an annuity is certainty of income while you are alive. You will never run out of funds and always have this income with an annuity, even if you live beyond 100.
Annuity rates are linked to long term interest rates, so they are quite low at the moment. For example, A 65yr male can expect an annuity rate of just over 5%,(basic annuity rate with Irish Life, no additional benefits). Adding any of the additional benefits will reduce this rate. This means the life company will pay 5% of the fund until death. The main disadvantage with an annuity is a short retirement life span. If the individual dies soon after retirement the fund is gone, unless there is a ‘spouse’ pension or ‘guaranteed period’ added.
Approved Retirement Fund – (ARF).
The alternative to an annuity is an ARF. This is a post retirement investment fund that allows the individual to maintain control of their fund. Firstly, unless there is already €12,700 of guaranteed pension income in place, the first €63,500 must be invested in an Approved Minimum Retirement Fund (AMRF). Only the growth on this AMRF can be accessed before 75, the capital (€63,500) can’t be touched. The remaining fund is then invested in an ARF which is treated like a post retirement pension fund. Any growth in an ARF is tax free however any withdrawals from the ARF will be taxed at your marginal Income tax rate. The recent Finance act stated there must be a minimum drawdown of 4% from this fund every year from age 61. The main risk with an ARF is the possibility of running out of money. With a min. drawdown of 4% per annum, the fund could “bomb out” in 25 years. Investment growth can protect against this longevity risk but also, any fall in investment performance could shorten this period.
Segmenting your Pension
Another possible options which is not widely used but may be beneficial depending on your circumstances is Segmenting your Pension. Simply put, this allows you to divide your pension pot into a number of smaller PRSA pots and retire each pot as needed. There are a number of benefits to taking this approach and these are as follows:
- You only take the amount of Tax Free Cash that you need at retirement, rather than taking the whole entitlement in one go. Remember, all growth within a pension fund is tax free but, as soon as you take cash out of your pension and reinvest, any growth could be liable to 41% DIRT or Exit Tax.
- When you take your tax free cash at retirement the remainder of your fund must be transferred to an ARF(as discussed above) which is subject to a taxable 4% withdrawal every year from the year you turn 61. Even if you don’t take this withdrawal, Revenue will deduct tax from your ARF as if you have taken a 4% withdrawal. However, by leaving the bulk of your fund in a PRSA and only taking the tax free cash that you need, your PRSA fund will not be subject to this automatic withdrawal.
- Finally on death, if you are invested in an ARF, the fund can transfer to your spouse tax free but the withdrawals are subject to tax. Alternatively, the ARF can transfer to your children. If they are over 21, it is taxed at a special rate of 30%. However, any funds you have invested in a PRSA transfer directly to your estate. Your spouse can receive this fund 100% tax free and so can your children, subject to not breaching the necessary inheritance tax threshold.
So how does it work?
Let’s look at an example. John is 65 and has just reached his Normal Retirement Age. He is married to Mary who is also 65 and currently receiving a pension of €30,000 per annum. John is a company director and plans to continue working in his business. His pension pot is €800,000. This means he could take up to €200,000 tax free and transfer the rest of the fund to an ARF. John has told his financial adviser that he doesn’t need to access his entire fund as he and Mary have plenty of income for the next couple of years. He has, however, said he would like to access €25,000. His other main priority is to save as much of his retirement fund so it can be passed to his 4 grown-up children when he and Mary have passed away. The best advice for john is to transfer his pension pot to a PRSA and segment that PRSA into 8 separate funds of €100,000. He can now retire one PRSA and he will be entitled to 25% of €100,000 i.e. the €25,000 he said he needed. The remainder of this fund must now go to an ARF or purchase an annuity. However, the remaining €700,000 remains in a PRSA where it will grow tax free, is not subject to any automatic taxable withdrawals or payment (which the ARF and Annuity are) and on death the fund can transfer tax free to his estate.
So what type of person is this approach most suitable for?
- Someone with a large pension fund at retirement
- Someone with post-retirement earnings from other employments, pensions or rental income etc.
- Someone with children that they would like to inherit the money
If you are approaching retirement, make sure you ask your adviser about segmenting a PRSA and if it would be suitable for you. Your adviser should be asking you questions like how much tax free cash do you need now? Do you need a regular monthly income in retirement? What level of risk are you willing to take with your post-retirement fund? Do you have children that you would like to inherit your pension fund? If your adviser isn’t asking you questions like this, you really need to wonder how good their advice can be, particularly if they’re unaware of this information.
If you would like to find out more please contact Declan Maher Financial Services Ltd on 087 1444977 or at firstname.lastname@example.org