We are going to run a series of blogs [6 to 8] to cover a lot of the aspects of business exits that we have been involved in over the last few years and try and highlight some of the common themes that keep occurring. When we talk about business exit this could be an outright sale to a third party or to the management team in the business or a full or part transfer to the next generation. I will be focusing in on the pensions and tax side of things and Ger will be looking at the valuations, negotiations and company law issues. This week I am going to focus on pensions and how proper planning in this area can not only utilise the cash in the business but provide you with a comfortable steady income in Retirement. I will be focusing on company pension schemes for owner company directors and looking at options at retirement in terms of drawing down the funds.
No point boring you to death with facts and figures but we all know the level of pension coverage in Ireland is very poor. Too few people have pensions. Therefore this means they will have to work longer to maintain an adequate standard of living or live off the State pension when they eventually get to draw this down. The key point here is that you need to get started. Not next year, next month but take action and get going now. The sooner you start the better for many reasons but the main one is that you are giving yourself a much better chance of having a larger pension pot at retirement, if you start in your 20’s than if you start in your 40’s. If you start much later you will have to put in significantly more money to arrive at the type of pension you want to achieve.
Why pensions in a company
The main reason is that the company makes the pension contribution for you so you don’t have to make the payment out of your net salary. Therefore your net salary stays the same but the company is using its cash to fund your pension. The company get a tax deduction for the payment so it is treated as an expense in the accounts. Although the saving is at 12.5% it is still a saving so a monthly contribution of €1000 would be a net cost to the company of €875. Another benefit is that the income and gains in the pension roll up tax free. This is fantastic as there are not many things in life that you will get tax free! The benefit of this is that as there is no tax on the income or gains within the pension so the fund can grow to a significant amount over time assuming investment performance is good and charges are reasonable.
The amounts one can put into a pension as a self-employed person [sole trader or a partner in a partnership] are limited by your age and your profit. The maximum profit is subject to a cap of €115,000 so if you had a profit of €150,000 then you would be subject to the cap. For a 41 year old self-employed individual the percentage of profit that they can contribute is 25%. Mary, a successful graphic designer, aged 45, made a profit of €60,000 in 2018. The maximum pension contribution that Mary would get tax relief on for 2018 would be €15,000, being €60,000 X 25%. If Mary was in a company and her salary was €60,000 the company could fund a pension for her that would give her up to 2/3rd’s of her final salary. Assuming her final salary, at retirement, was €75,000 then there is scope to fund a pension of up to €50,000 per annum. Based on an annual 5% drawdown, that could be a pension pot of up to €1,000,000. The key point here is that there is a lot more scope in company situations to make contributions and top-up contributions for company directors than there is for self-employed individuals.
Converting company money to Personal money
The company is contributing funds to the Director’s pension so what is happening is that company money is being converted into a personal asset of the company director. I see this as a form of long term savings for the director. In the unfortunate scenario of the director passing away during the term of the pension then the value of the pension is paid out to the spouse or to the Estate of the director. Therefore this would be a cash payment, like the proceeds of a life assurance policy, to the director’s family. If that went to the spouse there would be no tax on it and there may or may not be tax on it if going to other family members. Assuming the director makes it to retirement then the pot of money that has been accumulated is available to draw down and is an asset of the director, in most scenarios
Drawing down from your company pension
There are a number of options available and the key options you need to know about are;
Take a 25% tax-free lump sum with the balance going into an ARF/AMRF or an annuity
Take a lump sum of up to 1.5 times final salary with the balance going into an annuity
In most cases that we have been involved in the company directors went for option 1 although we had a case where option 2 was beneficial. The maximum tax free lump sum that you can get when drawing down a pension is €200,000. Therefore to get this maximum you need a fund of €800,000. Assuming you have this amount in your fund and you take your tax free lump sum you are left with €600,000. That can either be invested into an Approved Retirement Fund [ARF] or an Annuity. If investing into an ARF you can draw down this as you please, subject to normal tax rates, so there was a fear that you would deplete your ARF quickly and that you would have no Capital left. Therefore the Approved Minimum Retirement Fund [AMRF] was introduced where you would have to put a minimum of €63,500 of the balance of your pension fund into an AMRF, the capital of which couldn’t be touched until you hit 75. You didn’t have to invest into an AMRF if you have a guaranteed income for life of €12,700 at the time of drawing down your pension. The guaranteed income could either be a state pension or another private pension
The key benefit of going down the ARF/AMRF route is that the pension is your asset on which you can draw down an income from every year. This is effectively another pension asset and the income and gains roll up tax free in the fund but the income you draw down is subject to tax. However your tax rate at this age could be a lot lower than it is when you are working as you could have a reduced income but would hopefully have reduced outgoings too. The children could be paying you back all the money you gave them at this stage!!!
Taking the above example if you drawdown 5% of your ARF annually on a figure of €600,000 this would be an annual pension of €30,000. If you were also in receipt of the State pension that is an additional income of €13,000 so your combined pensions are €43,000. If you are married and this was your only income then all of this would be taxed at the lower tax rate of 20%
If you purchase an annuity you are giving the balance of your pension to an Insurance company and they will pay you an income for life which would be based on current interest rates. Annuity rates are quite low at the moment so your fund would have to be very high to get sufficient income. The key disadvantage of an annuity is the early death of the annuity holder. If you die early in your retirement the Insurance company will keep the remainder of your money. As opposed to an ARF an annuity is not your asset but that of the life company you purchase the annuity from
Why is it important in terms of Business Succession
- There are a number of reasons and some would be very relevant but very much on a case by case basis.
- Excess cash used to fund the pension of the owner Director
- Director exiting with sufficient income so may not need to continue working in the business and draw a salary so more scope to accumulate funds once Director has left
- Director may not want to continue working but has to, in order to fund living requirements, so can delay business transfer
- Cash needed on sale to third party or transfer within the family may not be as high if pensions are in place
- Too much cash on the balance sheet can cause a Revenue problem with some of the gift tax/inheritance tax reliefs such as Business Property relief
- Early transfer of a business, before 66, can be very tax efficient for the exiting directors in terms of Capital Gains Tax retirement relief
- The age of drawdown of state pensions has been pushed out. It will go to 67 from 2021 and to 68 from 2028. The writer is not happy about this!!
As an owner director of your company it is very important to plan for this. When meeting prospective clients a question we will always have on our agenda would be business exit and what the long term intentions of the business owner are. The reason we ask this is that we want the business owners that we work with to be taking steps to plan for their retirement and their business exit.
Since about March 2008 the returns on pensions have been very good in general and if you have invested in your pensions during this period your pension funds should have grown quite considerably. You should also be aware of your PRSI position and if you are on course to qualify for the full state pension.
I heard it said before that paying into a pension is like paying yourself first. Only you can take action on this.