How pension contribution can affect tax liability
Prepare to be inundated with advertising surrounding pensions, writes Justin O'Gorman, as the tax return deadline is upon us once again and we attempt to reduce our tax liability
Published 30/09/2010 | 05:00
WITH the deadline for filing a tax return coming up on October 31, the pension season is about to start.
Over the next few weeks there will be a huge amount of advertising in relation to pensions, so it is important to know why this time of year traditionally sees significant amounts invested in pensions.
It all comes down to tax or more importantly -- saving tax.
Every October 31, self-employed individuals must pay their preliminary tax for the present tax year and residual tax for the previous tax year.
Once their accounts are completed, the self-employed will be presented with a figure that represents their tax liability.
One way of reducing this tax liability is to make a lump-sum contribution to a pension.
This lump sum qualifies for tax relief at the individual's marginal tax rate, either 20pc or 41pc.
The tax relief the individual is entitled to on the contribution can be used as an offset against their tax liability, thus reducing the amount of tax that needs to be paid.
There are limits to the total contribution that can be paid to the pension and these limits depend on age as follows:
For someone between the ages of 20 and 29, 15pc of their income is the maximum that can be contributed in a year.
For those between the ages of 30 and 39, the limit is 20pc of income, with this limit rising to 25pc for those between the ages of 40 and 49. For the 50 to 54 year-olds the maximum is 30pc, while between the ages of 55 and 59 you can put 35pc of your annual income into a pension. For those over the age of 60 the limit is 40pc.
For those individuals on the higher tax rate, there is a more pressing reason to make a contribution to a pension.
In the recently published 'National Pensions Framework' there is a recommendation that the tax relief on pensions should have a standard relief rate of 33pc.
This is effectively a reduction in relief of 20pc for those who pay tax at the higher rate.
For example, an individual on the higher rate making a contribution of €10,000 would receive relief at the moment of €4,100.
Under the new proposals, the relief would drop to €3,300 -- a reduction of €800 or put another way, an increase in the tax liability of €800.
There has been no definitive date set for the introduction of this reduction of tax relief but with a Budget looming in December and the Government looking for savings of over €3bn in the next tax year, this could be one area that is looked at.
There is a second reason why making a contribution to a pension makes sense. On October 31, a self-employed individual also pays preliminary tax for 2010.
This payment can be 90pc of the expected 2010 liability or 100pc of last year's liability.
As most people don't know what their total liability for 2010 will be, they take the option of paying 100pc of last year's liability.
By making the pension contribution and offsetting it against last year's tax liability, they also reduce the initial payment for 2010.
Here is a worked example.
Joe paid preliminary tax in 2009 of €10,000.
After finalising his books, he finds that he has an additional tax bill of €4,000 to settle for 2009 by October 31 this year.
If he makes no pension contribution he will write a cheque for €18,000 payable to Revenue.
This represents the balance of last year's tax as well as preliminary tax for this year.
However, Joe decides to make a contribution of €5,000 to his pension.
As he is a 41pc tax payer he receives relief of €2,050 on this contribution.
This means that his final tax bill for 2009 is €1,950 instead of €4,000.
Now Joe writes two cheques, one for €5,000 payable to his pension, and one for €13,900 which represents his final tax for 2009 and his preliminary tax for 2010.
Because Joe reduced his final tax for 2009 by €2,050, his preliminary tax for 2010 is also reduced by this amount.
While his overall outlay has increased by €900, he now has €5,000 invested in his pension.
While there have been a lot of articles about the poor performance of pension funds over the last decade as a result of recent market volatility, there is so much fund choice available in the market today.
The most important thing that any individual can do now is seek proper independent advice in relation to their pension and not be bamboozled by all the offers that will be made by the various life offices in the weeks ahead.
- Justin O'Gorman QFA, is a senior financial adviser with MyAdviser.ie.