Pensions are boring but they are still the best way to earn money tax-free

For most people, talking about pensions probably rates somewhere between watching paint dry and standing in line at the post office. It’s usually very boring with the additional side serving of complex jargon.

It’s hard to get excited about something we won’t be able to get our hands on until we’re in our 60s. Locking away for years cash that could be spent on things now feels too much like reward delayed. Especially at a time when our grocery receipts and energy bills tell us that rising prices mean our cash is not going as far as we would like. May was the twentieth straight month where the annual consumer price index rose by at least 5 per cent in Ireland.

Young Irish people trying to scrape together a house deposit while paying record rents might be inclined to deprioritise pensions entirely. That could leave them doubly disadvantaged as they get older – waiting longer to buy a home and thus delaying investing in their retirement.

And as if this wasn’t already bad news, a “pension time bomb” is looming. Put roughly, like countries across the developed world we are heading for a time when too many people will be tapping the State for a pension and not enough people will be working and paying the tax needed to fund it. This could see government increasing the age we can access the State pension – which the government previously said it would do before but backtracked on the issue – or it could mean a reduction in the amount paid in contributory State pension amount by the time we retire. And without a private pension to help fill the gap in your budget, we could feel the pinch.

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So, despite the uncomfortable financial environment many of us find ourselves in, now is actually the best time to start thinking about the future and what kind of retirement we want to have.

Ask what pensions can do for you

Pensions may not be as much fun to save for as a holiday but, as Daragh Cassidy from comparison site Bonkers.ie explains, they do have an upside.

“At the start people get very confused about taxation and pensions. It absolutely bores people to death,” he says. “But if you say [to people] ‘would you like to know the most efficient way to earn more money tax-free’, people say ‘absolutely’.”

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Saving into a pension offers tax relief on contributions. This relief is set depending on which rate a worker’s income tax is set. For 2023, if you earn more than €40,000 a year, you will get relief at 40 per cent on money you put into a pension; below this level, the relief is granted at 20 per cent.

This means money that would otherwise be taken by Revenue in tax gets redirected to your pension. That means more money for you in the long run. Unfortunately, there is no relief on PRSI and universal social charge on contributions by an employee into a pension.

“As an example, if the 40 per cent rate is what you are on and you receive €3,000 net income a month into the hand... and you put €100 into a savings account, you will have that €100 plus any interest, on which you will pay tax,” Cassidy explained.

“But if you put €140 in your pension, you will actually still be left with that €2,900. The extra €40 that you were able to put in the pension comes from tax relief.”

Which is quite a large amount of relief, given that regular savings are subject to the Deposit Interest Retention Rate (DIRT), which means stumping up 33 per cent of any interest you might earn to the tax man.

The amount you can invest into a pension fund while getting tax relief increases as you get closer to retirement. For example, under-30s can get tax relief on contributions up to 15 per cent of their income; by the time you get to 55 years old, you can stash up to 35 per cent of your income into a pension and get tax relief on all of it up to certain limits. The most anyone can contribute in any one year and get tax relief on is €115,000.

Starting early is easier

While it might seem counterintuitive to start paying into a pension when you might be at the lowest paid stage of your early career and struggling to afford a home, it’s actually the best time. When it comes to long-term investments like pensions, time is one of the best tools available to you to create a bigger return in the long run.

This works in two ways when it comes to pensions. The first is compound interest. Any growth your invested pension fund generates is rolled over year into year, snowballing into a larger amount.

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As Ciaran Hughes, a financial planner and ethical pension specialist at Ethico, explains: “Compound interest and time can supercharge your savings. One thousand euros invested the day before you retire will just be €1,000 on retirement. One thousand euros invested from age 30-65 at 6 per cent growth and [subject to a] 1 per cent charge will be €5,516 at retirement [ignoring inflation].”

However, Hughes warns you will reap the benefits of time and compound interest only if you actually commit to contributions. “Some people will be putting in €25 a month and thinking ‘yeah I’ll be grand’,” he said. “Pensions are an amazingly efficient tax way of saving most but they’re not magic.”

So how much should you be putting in? That number changes for everyone, depending on whether you have a workplace scheme where your employer makes a contribution on top of yours, the amount of money you currently make and what your ambitions are in retirement.

As a benchmark for under-30s, Hughes sets a contribution level of about 8 per cent if you start your pension at 25. For a career in which earnings average €50,000 and you are looking for a pension of €30,000 a year including the State pension (currently €13,172 a year) with 6 per cent investment returns and a 1 per cent charge, the number increases dramatically with age according to his calculations.

If you were to try to reach that same pension but didn’t start until 35, you would have to put in nearly double the amount in contributions – 15 per cent of your income – to catch up. If you do nothing until you are 45, that more than doubles to 40 per cent which would be incredibly hard to achieve. So paying a small bit consistently from the start might save you from having to sacrifice nearly half your income later on in a bid to make up lost time.

“Time is our biggest grower of pensions. For younger people, the pressure is on to save for that house deposit. Everyone is in a race against each other for limited housing stock and they think they’ll sort their pension later but they’re equally important,” Hughes said.

As a general rule when figuring out how much money you might need to live off when you retire, you should aim for two-thirds of your final income, according to Cassidy. That can go down to half in some circumstances. Subtract the State pension currently at €13,172 (but subject to change) and that’s what you’ll have to generate every year from your pension to live off.

For a person earning €60,000 a year, they should aim to have €40,000 which means they need to have a pension of €26,828 from which they can draw down. If that number sounds unachievable, remember this isn’t just made up of the cash you put in. It also comes from employer contributions, growth and compound interest.

The Pensions Authority has an easy-to-use calculator on its website that tells you how much you should aim for depending on age, income, needs and current scheme.

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Find the right fund for you

If your employer has a pension and offers contributions, you usually have to join its preferred scheme to benefit. These are called occupational pension schemes. Usually your HR department will help you apply during the onboarding process.

If your employer does not offer any pension benefits, you are free to choose your own in the form of a PRSA – a personal retirement savings account.

Unlike other countries, employers in Ireland are not legally bound to contribute to your pension though that is set to change with a new mandatory enrolment scheme scheduled to be rolled out in 2024. Auto-enrolment will see anyone earning more than €20,000 a year and aged 23-60 who isn’t already in a pension enrolled in one. Employers will have to match employee contributions up to a certain cap with the State kicking in a bit on top in lieu of tax relief.

People looking to explore pension investment options should be aware of tricky fee schedules, according to Cassidy.

“Be wary of the charges and pay attention to a metric called reduction in yield,” he said. This is the easiest way of knowing what fees and charges a pension will take from you in total every year. One pension could have a lower management fee but higher allocation fees. Another fund might have a higher management fee but no allocation fee, making it the better deal.

Overall he advises to go for the best managed and diversified fund with the lowest charges.

Finally, you need to be aware that pension investment does come with risk – 2022 was a bad year generally on this front – and there are different levels of risk available from high risk/high yield to more slow and steady investment strategies. It’s important to get independent advice from a financial planner, says Hughes.

“Don’t be afraid to pay an hourly fee rather than relying on someone who is paid through commission out of a pension they sell you and ending up with something that isn’t right for you.”