16th July 2018
Welcome back to Ireland’s award winning Finance Blog & Podcast. Delighted you have joined us! Our mission is to help people avoid mistakes and help themselves to live successful financial lives. Our big aim is to ultimately change how financial advice is done here in Ireland, to put the focus back on what you want to achieve, not the products that only really serve as the tools to enable you to do it!
This week we are exploring a much-covered topic. It has not been much-covered by us but if you google ‘Director’s Pensions Ireland’ you will see 3.9million results, and every single one of them is trying to flog you one! However we are not talking about the pensions themselves here today, we are talking about the much more important aspect of all of this and focusing on the ‘planning’ aspect, the bit is (or at least should be) central and should come before the ‘product’ (pension!). We will compare the stories of 2 fictitious brothers, who have very different approaches to life, and who go about planning in 2 very different ways!
Brother 1: Johnny – aged 41
Johnny is a bit of a stud. He is 6ft 1″, with abs like a wash-board, the life & soul of every party going. He is into the Triathlons, Yoga, Rock-Climbing and driving fast cars. He is your typical movie-star soft of a guy! He is a company director, owns the business outright and the company import luxury watches. Having built the business up over the past 2 years only the business is flying it, profit of €250,000 on turnover of €3m per year. He is taking an income of €180,000 and as he has no mortgage at all and no family to support he finds that more than enough to support his lavish life-style. After tax he is taking approx €85k per year out of the business, €7k a month into his hand proving to be sufficient for now.
Brother 2: Alan – aged 45
As you have probably guessed by now Alan is not at all a stud! He is short, round and a bit of a recluse! He is into reading the Financial Times and reads really boring Finance Blogs & listens to Finance Podcasts (who would do such a thing!). He drives a 2002 Toyota Avensis with 300,000 miles on the clock! He does however have a very analytical brain, and is keen to ensure that his business, which imports calculators (of course!) provides for him and his family sufficiently over the years. He works really hard, puts in long hours and has built the business up over the past 5 years to a stage where it is going well. His business is as equally successful as Johnny’s, delivering the same amount of turnover and profit. Johnny however takes a slightly lower income of €160,000 per year. He has found that to be the correct amount of income to take that will support him and his family, ensure he has enough to build a suitable Education Fund and to build a sufficiently large Emergency Fund for themselves, and to enjoy 2 family holidays to Tramore every year!
Johnny & Alan are in the car one day driving to a funeral when they hear an interview on NewsTalk with a Financial Expert who is talking about the merits of Pensions for Directors & Company Owners. Johnny tells Alan that ‘all that pension stuff is a load of nonce’ & that ‘yer better off spending your money while yer alive and well, sure you can’t bring it with you’! Alan however is keen to do some thinking about what he wants to do and how the business can help him do it. Johnny dismisses the notion, preferring instead to Carpe Diem, and to keep the good times going!
Alan gets home after the funeral, realises that he is indeed mortal, and has a decent chat with his wife Mary about what they want out of life. They have both been working hard for the past 10 years, raring their 3 kids, the youngest of whom is now 12, building the business, all-the-while Mary has been working away as an editor in the local paper. Ultimately they want to be able to do the things they really enjoy, and do plenty of it as soon as they possibly can. Realistically they are thinking that it will be at least 13 years before the last of the kids leave the nest, so they aim for being financially independent, and more importantly free from the business by 58 years of age.
At that stage they see themselves passing the business to one or more of the kids, taking 4 long term holidays per year, spending time with their kids and (hopefully grand-kids). Financially they want to be in a position where they do not have to worry about money in any way, to have sufficient money to decide to do whatever they want and whenever they want (within reason!). In their heads they feel they would need approximately €50,000 income per year from age 58 to do this. They also feel quite strongly about leaving a legacy, a sizable chunk of funds for their kids and grand-kids, to pass on their good fortunes in some meaningful way. If that is all possible!
But how can they do this? In his head Alan knows that he takes as an income is taxed essentially at 52% (Income Tax 40%, PRSI 4% & USC 8%). He therefore concludes that it would be utter madness to try and create the desire personal wealth out of the business by increasing his income he’d just be handing it to the revenue!
So he decides to take the plunge, hire an independent financial planner who might be able to show the way and help him create a plan that will deliver the outcomes that they want, namely;
When the Planner came back a few weeks later with a plan that suggested the realisation of their goals was within reach they were intrigued!
While nothing, as we all know, in life is guaranteed to work out exactly as planned their financial planner does the research necessary and creates a meaningful plan that is highly probable of delivering their objectives and goals.
Alan was uttery gobsmacked to learn that under Revenue Rules as a Director his company is perfectly entitled to contribute really really huge amounts of cash directly from the company accounts into a retirement plan (which would become his personal funds and totally ring-fenced from the company!). These ‘really huge’ figures are calculated based on his age, his marital status & his partners age, his gross income from the business, his planned retirement age, his retirement benefits from this company and from previous employments. All this data is bashed into a calculator and shows Alan that, if the business really wanted to and was capable of doing it, could contribute over €300,000 PER YEAR for the next 15 years, from the company accounts and into a retirement structure for him! Alternatively the company can make a ‘special contribution’ for ‘past service’ of €1million right now and then a reduced annual amount of €200k per year!
When he learns that if he were to do the former option and these funds were to achieve 5% return per year on average he would have a fund of over €5m at retirement age, and that anything over €2m is taxed in a very aggressive manner he determines that that approach is just plain senseless, that it sounds nice but is a waste of time and money on his part!
So what is the right amount for the company to pay into his directors pension plan? Well luckily the planner took the sensible approach and ‘begun with the end in mind’! Alan and Mary want to have approximately €50,000 income from their pension pot when they retire (separate to the State Pension they will be eligible to). They will want to take these funds from the age of 58 and to do so in a manner that suits them. Some years they may need more and some years they may need less…..they want to have control over that and to take it or leave it at their discretion.
Alan wonder’s ‘what pension pot will I need to give me the income I need’? Thankfully the planner has done the calculations on this and has determined that if they had a retirement pot of €1m at age 58 they could draw 5% per year from it (€50,000), and provided they leave the funds invested in a well diversified portfolio of majority equities (a small remainder in Bonds) they would expect to retain the bulk of their capital over the long term. This strategy is based on historical returns over the past 9 decades which has shown a suitable equity portfolio delivering closer to 10% per year. If they are drawing an income from, and indeed depending on this resource for the next 30-40 years from 58 then they surely want it to continue to grow and at least keep abreast of inflation over that term. The solution is to ensure it remains invested post retirement. (this whole beautiful topic is for another day!).
How To Make It Happen?
So they now know they need to have €1m in their directors pension when Alan hits 58. That is the financial goal and it is time-bound and realistic. It is a sensible approach. But ‘how much does the company need to contribute to my pension to grow to €1m by that time’, Alan wonders? He believes that the company can realistically afford to contribute €3,333 per month (€40k per year) to his pension pot before it would put a strain on his cash-flow. He also recognises that there is a large amount of cash in the business accounts and feels that it would be better put to good (personal) use!
Based on these factors the planner shows that if Alan’s company, based on Alan’s age and circumstances were to make a ‘special contribution’ of €160,000 right now to a suitable pension structure (more on this in coming weeks!), and then to contribute €3,333 per month for the next 13 years, and achieve even 5% net return average over that time that Alan would have a pension pot of €1.01 million at the age of 58, and in a position to do exactly as he and Mary have determined they want to do.
So as to ensure we are all clear on this; Alan’s limited company commit to contributing the above sums now and over the next 13 years as a deductible business expense and with no Benefit in Kind for the Director, claim the Corporation Tax relief on all these payments, transferring the funds out of the company and into Alan’s name totally legitimately and tax efficiently and well well below the allowed limits, and Alan & Mary get to achieve their life goals and their financial independence exactly when they want to and to have total control over when and how they do it………in addition when they follow the approach and guidance of their planner they will realise that even after drawing out the €50k per year from their fund as income, and that even if they both live to 130 their starting capital of €1.01million should be either totally intact or have grown over that period, and which then passes into their estate and to their loved-ones when they rock-on! It’s party time!
Johnny on the other hand continues to take his large income, continues to pay tax on every cent that he takes out of his business, continues to be unable to put money aside in a tax efficient way, and unfortunately his bias against planning for the future results in him losing-out on one of the greatest and last-remaining tax efficiencies that there is. Poor Johnny!
Which would you rather be!?
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