How do pensions work?

PPP, EPP, PRSA, AVC, PRSA AVC, SSAS, ARF, AMRF, OPS. Confused yet? You should be. These are different kind of pension plans yet they do the same thing. Pensions used to be fairly simple have become very confusing over time. So, how do these different pension plans work?

In its simplest form, a pension is a savings plan for your retirement with terms and conditions. One of the good terms is that you get loads of tax breaks. One of the bad conditions is you can’t get the money until you are 60.

I am going to look at 3 main areas of pensions that are common to all of the different pension plans mentioned.

 1. Pension Contributions/ Premium

To have a pension, you have to make a contribution into it. The more money you put in, the better your pension should be at the end. You can pay your premium from your own money, your employer might pay it or it may be a combination of both.

If you pay the money personally, the Revenue will give you tax relief at the marginal rate. That means that if you pay €100 into a pension and pay tax at the highest rate, you can claim back a refund of €41 back from the Revenue. Likewise, if you pay tax at 20%, you can claim a refund of €20 from the Revenue. If your pension contribution is taken directly from your salary, the tax relief is granted there and then so you don’t have to submit a claim to the Revenue at all.

If your company pays the contribution, they can write it off as a business expense.

2. Pension Fund

So where does your contribution go? It has to be invested somewhere so it will grow. In the vast majority of cases, it will go to an life assurance company who will invest it for you.

Where it is invested is up to you. Life companies have a vast range of funds available from the very safe funds like cash to the racier type funds such as Indian or even Irish equities. You can choose what funds you want to invest in and can pick a selection of a number of different funds.

But be warned. While the racier funds might show really good returns, they are also capable of falling by just as much if things go wrong. You have to decide what is your “sleepless night” level i.e. when will you start having sleepless nights over your risk exposure, and invest accordingly. A good adviser will help you to match the level of your risk exposure to your comfort level.

And the Revenue will give you a hand out again; the fund grows tax free.

 3. Retirement

From the age of 60, you can draw down your pension benefits. The size of your fund is dependent on how much you invested and how well your investments did.

When you mature your pension, you get a tax free lump sum, which can be either 150% of your final salary or 25% of your pension fund. It cannot exceed €200,000 though.

The rest of the fund is then used to provide you with an income for the rest of your life. You can either give it to an insurance company who will provide you with a fixed income for the rest of your life or you can manage it yourself and take money out as you wish (as you control everything, there are no guarantees).

Now the bad news. You know the way the Revenue gave you tax breaks on the money you paid in and then let it all grow tax-free? Well, now that you are drawing down your pension, they are going to tax you on it. When the money is taken out, it is taxed under PAYE, just like you were taxed when you were working.

And that is how a pension works. Of course, this is just a basic explanation and there are loads of differences between the different plans available.