How do I plan for retirement and why should I save for retirement?
Planning for your retirement is a different challenge than funding your retirement. The former may involve a fundamental reappraisal of how you live your life and spend your free time whilst the latter is very much connected to financial planning and tax efficiency. We will return the emotive topic of how you may plan to spend your time in retirement and what you can do to help create a “second life” in retirement. But for now, I wish to concentrate on the hard finances of funding your retirement.
Of course, the easy thing to do is to do nothing – the State will provide, I will not go hungry! This is a very naïve and simplistic approach, not to mention financial suicide. The State do actually provide but not enough to live comfortably. The State contributory pension amounts, to €12,956 p.a. This represents approx. 1/3 of the average industrial wage but the quantum of entitlement may change into the future, if recent remarks from Minister Regina Doherty are to be believed. The state contributory pension age is now age 68 and may potentially rise again, if recent changes to the age of entitlement are any guideline.
Who wants to retire on a pension 2/3rds less than the average industrial wage? Our own anecdotal research would suggest that people aspire to a minimum pension of 50% of their salary at retirement so invariably the required total pension is well in excess of €30,000 p.a.
Increasing life expectancy, advances in medical science, a desire to see the world, visit children and grandchildren in far flung destinations, an appetite to sample the variety of life, are all factors that make providing for the future all the more imperative.
Indeed, in many instances, we see retirees access their retirement pots, in order to help their children, put deposits down on new homes, because the kids cannot afford to get on the property ladder otherwise. In many cases the parents can ill afford to give away their retirement lump sums in such a fashion.
So how much should I be paying into my Pension Fund?
Quite simply, we recommend that you avail of the maximum age-related pension contribution that the revenue permit, ranging from 15% to 40% of earnings (subject to limits). There are more generous contributions allowances for company directors. This is a tax break the government actually permit, but only the few take advantage of. As a wise man once said to me; this is the government endorsed minimum level of contribution for different ages- you would be made not to use it. But there are other tax breaks connected to pension funds which you may not know about:
- A pension contribution is fully tax deductible at the marginal rate.
- Pension contributions are invested in funds that are not liable for tax.
- A tax – free lump sum can be accesses at retirement date of 25% of that pension fund (within limits).
- In many instances, due to the benign tax regime for people aged over 65, the income from the pension will be liable for little or no tax.
That is a lot of tax breaks.
Let’s look at an example
Sean, who is married starts a pension fund aged 45 and pays €750 p.m. until his retirement at age 65. He pays total contributions of €9,000 p.a. x 20 years = €180,000. His net cost is €108,000 because he gets tax relief at 40% on all contributions paid €5,400 x 20 years = €108,000.
The pension fund achieves a modest growth rate of 4% p.a. net of costs, in a balanced fund. The final pension fund has a value of €367,000 at age 65.
Sean takes his benefits as follows:
- Tax Free Lump Sum 25% – €91,750
- Remainder Pension Fund €275,250 invested into AMRF/ARF
He draws a pension income down of 4% p.a. (€11,010) from the remainder pension fund of €275,250. There is an income tax exemption for those age 65 or over, if total income is less than €18,000 p.a. for a single person or €36,000 for a married couple. So, this income of €11,010 is TAX FREE
Later, when the State Contributory pension becomes payable (at age 68 in this instance) an additional income of nearly €13,000 will become payable to Sean. The aggregated total pension income of €24,000 p.a. will not be taxable in this instance.
So, Sean gets practically all his net investment returned to him on the day he retires. He paid in a net €108,000 and he gets back €91,750. PLUS he will receive an ongoing income of €11,010 every year, until he dies or his fund is exhausted. This income of €11,010 will not be liable for tax either.
That is not a bad way to save for the future.
Talk to us now about ways in which we can structure tax efficient pension and draw down strategies to maximise your income in retirement.
Pat O’Dwyer B.Comm, MSc, QFA, CFP®, Managing Director, City Life Galway