Retirement options: What should I do with my tax-free lump sum?
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of Mercer advises people to ensure that their money is invested in a way to best match their future needs
At retirement many people focus on one important question: “Should I take out an Approved Retirement Fund (ARF) or annuity?”.
However, it is also important retirees consider another question: “What should I do with the other part of my pension — the retirement lump sum?”.
Under our current pension and tax systems, retirees are entitled to a once-off retirement lump sum, some of which can be paid tax-free. While there may be some additional considerations depending on the specific circumstances of individuals, the following rules generally apply to the calculation and taxation of the retirement lump sum.
It can be calculated in one of two ways and may depend on the type of pension an individual has. In the first, individuals take 25% of their pension as a retirement lump sum. In the second, they receive a retirement lump sum based on final remuneration and the length of time spent working with that employer (this method applies to company pension schemes and Personal Retirement Bonds).
The maximum tax-free lump sum is currently €200,000, and it is important to note that this is a lifetime limit and includes all pension arrangements. If an individual is entitled to a lump sum exceeding €200,000, the excess over this level is taxed at 20% (up to maximum of €500,000). Any lump sum in excess of €500,000 is taxed as PAYE at the marginal rate (40%).
The reality is that most guidance at the point of retirement focuses on helping individuals navigate their choice between an ARF or annuity and the retirement lump sum is often not given the same attention in this process. This is likely because it is paid directly to the individual’s bank account and essentially leaves the pension system.
However, annuities, ARFs and retirement lump sums are all sources of retirement income and good advice should include how to use each income source effectively to provide the retiree with a good standard of living in retirement. Ignoring the lump sum and leaving it on deposit with the bank can be detrimental to retirees later in life as interest rates generally fail to beat inflation over the long term, thus eroding the real value of the lump sum.
This is a problem recognised by the Government — The Pensions Council, a working group established by the Department of Social Protection, published a paper on the retirement lump sum last year that highlighted the frequent mismanagement of retirement lump sums and noted that 60% of retirees left their lump sums on deposit, which left them at risk of being eroded by inflation.
So, why are retirees leaving their money on deposit? Well, it is important to firstly note that in some cases this can make sense — for example, the retiree might intend to pay off their mortgage or another debt, create an emergency fund (3-6 months net income is a good rule of thumb) or they might have large expenditure planned over the coming 5-7 years such as a purchasing a car, house renovations or gifting money to children.
Others may be naturally risk-averse, and it may be right for them to leave this money in a fixed-term deposit account or state saving scheme. However, unfortunately a large cohort of retirees leave money on deposit because of a lack of guidance and in some cases poor advice.
Many are probably guilty of procrastination — at retirement they put investing the money on the long finger with the intention of revisiting it in a year or two, but years go by, and the money sits in their demand deposit account (or worse current account) and earns little or no interest.
As part of the preparation for retirement, it is important that individuals consider their likely future expenses. They should set out their expected ongoing costs and large one-off expenses over the first five to seven years of and then they should consider their investment options for the remainder of their lump sum. The lump sum can be an important component of a retiree’s future income.
They should fully consider their investment options to ensure that it is invested in a way to best match their future needs, and these needs will likely differ across individuals. For defined benefit pensioners or annuity recipients, they have the security of a steady income stream in retirement but may not have capital at their disposal to help pay for important costs later in life such as nursing home costs or house renovations. Putting the lump sum aside and investing it appropriately could help fund these costs.
Those who opt for an ARF may also need access to more capital later in life and it could be argued that once short-term expenses are covered, a similar investment profile may be appropriate for both the lump sum and ARF — both are long term investments.
It is important retirees start viewing the lump sum as a pension asset and ensure that they have all the information they need to make the right decision for their specific circumstances. As always though, each person’s circumstances and attitude to risk is different and it is important to seek expert financial advice to help navigate that decision.
Fergus Moyles QFA, CFP®, MSc., Head of Private Wealth Strategy is a Financial Planning Consultant with Mercer (Ireland) Limited. Mercer (Ireland) Limited, trading as Mercer, is regulated by the Central Bank of Ireland.