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Pension Threat? Back  
Two separate reviews of the tax treatment of pension provision are under way. The ‘tax cost’ of the tax treatment of pensions may be misunderstood. The real problem may be under provision of pensions.
Nature of a pension
The purpose of pension provision is to provide income when a person’s active economic life is over or has been wound down. That income can be provided in many ways. An individual may build up private wealth in the form of cash, property, or equities is some form of ‘pension provision’. Pension provision usually takes the form of contributions by the individual to a pension scheme during their active working life, or contributions by an employer on behalf of an employee, to such a scheme.

In the bad old days these two forms of provision for old age were in sharp contrast. Building up private wealth left you with a nest egg that could be inherited by your family. A pension provided from a scheme typically yielded only an annual income that usually did not survive the individual’s death or at most, the death of the spouse, if later. It left no nest egg after death for dependants.
John Bradley

That harsh contrast is to a large extent history. An individual can elect to convert his retirement annuity contributions, additional voluntary contributions, or entire pension fund in the case of proprietary directors, to an approved retirement fund (ARF). That fund can represent a nest egg available to dependants after the individual’s death. Additionally, they can (and always could) commute the tax free part of the pension fund into a capital sum freely available to the individual as a nest egg. In the light of the new flexibility offered by approved retirement funds the comparative tax treatment of building up private wealth, as opposed to building up pension entitlements may be a much more important factor in deciding between the two means of providing for old age.

Is there a tax cost to the State?
Statistics produced by the Revenue Commissioners would suggest that tax reliefs in relation to approved pension schemes are amongst the most expensive tax reliefs in the tax code. This perception may not be a valid one.

In considering whether the tax breaks for pension provision have a real cost to the State, it is useful to compare the tax treatment of pension provision with the tax treatment of other forms of building up wealth for retirement.

If an individual saves his after tax income or gains and invests them in assets, he will pay income tax on the income from those assets and will pay capital gains tax on any gains on the disposal of those assets. Some forms of investment (eg funds) do not involve capital gains tax on turnover of underlying investments, nor do they involve an annual income tax charge at the marginal rate of tax. Such funds are (generally speaking) gross funds ie do not pay tax directly, and the only tax charge suffered is a 23p.c. exit charge when the individual draws moneys out of the funds. The last Finance Act did introduce a seven year capital gains tax charge on the growth in value of investments in the funds but the broad principle described remains true. However the moneys which the individual saves will typically have borne income tax or capital gains tax before it becomes available to him for investment.

In contrast, an individual suffers no immediate tax if an employer makes contributions to an approved pension scheme on behalf of the employee, and the individual gets tax relief against income tax for contributions which he may make (subject to limits) to such schemes. The pension schemes themselves are exempt from tax on their income and on their gains. However any sums paid out of a pension scheme (or out of an approved retirement fund where a pension scheme has been converted into such) suffer tax at the individual’s marginal rate of income tax.

Therefore even if a pension fund has been built up substantially from capital gains (which would otherwise have attracted a tax rate of only 20p.c. in the individual’s own hands) when that money is distributed to the individual, it will suffer income tax at his top marginal rate, which will often be 42p.c. at present.

The broad picture thus is that the tax relief obtained up front on contributions to a pension scheme by the individual or by his employer, and the tax exemption of the scheme in relation to its income and gains, are balanced by an income tax charge on the pensioner as money emerges from the pension scheme. While there may be some cases (where pensions are small) where the original tax relief was obtained at the marginal rate of 42p.c. but the pension is taxable only at the standard rate of income tax of 20p.c. by reason of its small size, it is equally true that in many instances there would otherwise be capital gains tax at 20p.c. (arising within the fund) are effectively converted into income taxable at 42p.c. in the hands of the pensioner at a later stage. There are thus swings and roundabouts but overall a broad balance in the scheme of taxation so that the tax reliefs are in reality deferrals of tax rather than tax exemptions.

Given that the tax reliefs are largely (but not entirely) a deferal of tax to a later year, it seems quite wrong to focus solely on the amount of the tax relief in respect of contributions to pension schemes in a year, and describe the resulting measure of that relief as being the cost of pension reliefs. To do that takes no account of the fact that much, if not all of that tax relief is being recouped each year in tax charges on pensioners as pensions are paid out of pension schemes.

If the cost of tax reliefs for pensions are to be measured, it can be done only by taking into account the tax levied on pensions when they are paid out. Unless that is done (and it is doubtful if the necessary information is available) it may be misleading to describe the tax regime for pensions as having a cost to the State.

It is true that not all payments out of a pension fund do attract income tax. As stated earlier, some part of a fund can usually be commuted into a tax free lump sum, and in some circumstances only, an approved retirement fund may suffer inheritance tax rather than income tax on being passed on to the next generation. Broadly it is true to say that the overall scheme is one of deferral of tax and therefore the true cost of the scheme can only be measured when the revenue from the deferred tax is taken into account in the calculation.

These comments regarding cost of pensions do not take into account the hidden saving to the State involved in pensioners having made provision for own support in their old age, thus ensuring that they do not become a burden on the State through the Social Welfare and health systems. Particularly when that factor is taken into account it is probably a fallacy to think of pension reliefs as having a cost to the State.

There is nonetheless a serious risk that a focus on one element only of the pension tax system ie the relief given in respect of contributions to pension funds and in respect of the income and gains of the pension funds, may give the misleading impression that there is a substantial cost, and that that in turn may influence government policy towards pension schemes.

The Reviews
The Minister for Finance has acknowledged receipt of a report from the Pensions Board, on foot of a review which it has been carrying out inter alia in relation to the tax regime for pensions. There is speculation that the content of the report may lead to changes in the taxation provision for pensions, in the forthcoming budget in December 2005. Separately, the Review Group on Tax Incentives are also looking at (inter alia) the tax regime for pensions.

The content of the Pension Board report is not in the public domain. While the Pension Board contains a high level of expertise, it does not have a monopoly of wisdom. It would seem preferable that the Minister should consult widely, and transparently, before making any decision on significant changes to the tax regime for pensions. Ideally, he should publish the Pension Board report and leave it open to comment and debate from all interested parties, before he takes any action.

The culture of secrecy in relation to proposed changes to taxation systems is unhealthy. It does not lead to good legislation. It is in sharp contrast with the position in the UK where proposed changes to tax systems are regularly the subject matter of consultation papers or white papers, leading to a very comprehensive and informed debate before decisions are taken. In Ireland, it is too often the case that we legislate first, and debate the wisdom of it later.

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