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Pensions for Business Owners – 3 Pitfalls! Blog 168

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Pensions for Business Owners – 3 Pitfalls! Blog 168

20th March 2021

Paddy Delaney

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Pensions for business owners can be a case of all duck or no dinner! Here’s how. This week I’m going to share some key planning opportunities, and threats, in regards pensions for business owners. I’ll go as far as to say that business owners should be aware of these potential threats, and should be actively aware and planning to avoid them. Worth mentioning that many of these also impact PAYE workers.

Firstly, thanks to those that got in touch after last week’s piece where I had a rant about the reputation of financial services in Ireland, and compared Team Sky and Team Davy! If it came across that I am disillusioned with FS in Ireland, I am not, but being a realist acknowledge that the ‘profession’ has a very long way to go and behaviours to correct before people will trust it. Anyway, back to the topic in hand…

Great Business – Great Opportunities

Pensions for business owners is a fairly staid topic but the truth is that anyone that runs a successful business has some fantastic planning opportunities. Planning opportunities that enables them to look after themselves and their loved-ones.

When I talk about ‘successful business’ here I guess I define that as a combination of both financial and non-financial metrics, where you and your business:

  • Has Positive cashflow
  • Does work that matters and which you enjoy
  • Has Revenue significantly higher than costs
  • Has a pipeline of paying customers
  • Work the hours you want (in so far as is possible!) with people you like

That’s just my wish-list when it comes to business anyway – your metrics may obviously be completely different. Either way, if your business is financially successful there are some great financial planning opportunities that you can/should consider and may already be availing of. Speaking of wish-lists, here’s the 101.

Planning Opportunities 101 – Pensions for Business Owners

First thing to acknowledge of course, is that if you were a PAYE worker, your employer would pay for most of the benefits we’re about to mention. As a business owner you’ll need to get your company to pay for them. There is an opportunity cost to that – because instead of investing in these opportunities for you, you could direct it to pay you more salary etc (which may make zero tax sense – but it’s an opportunity cost nonetheless).

I’ll refrain from verbosity in outlining these opportunities, you’ll know all of these opportunities already, but to summarise;

a) Protection: Your business can and should put in place income protection and life cover of various sorts that would benefit you personally if you were unable to work or were to die while working in the biz. Check out our interview with Nick McGowan of lion.ie in Podcast 207 for the low-down on these aspects

b) Retirement Income: Your employer (your business), just like any employer, big or small in the State, is entitled and indeed encouraged by Government to provide for your retirement. In encouraging it, the Revenue allow an employer to make potentially very generous contributions to an employee’s approved pension scheme. The level of contributions can be so generous indeed that the vast majority of employers don’t go anywhere near the maximum limits.

Of course, if you control the business and it’s finances allow it, the employing company, can max these limits if it so wished! Pensions for business owners is a big opportunity if done right. Here is Blog 123 where we detailed one of the best pensions for business owners available.

c) Investing: A big deal for some, but in many ways you’re just delaying inevitable taxation! Any company in the state is entitled to invest company cash over a period of time in order to try get some return on the cash. The cash stays within the companies ownership, and can benefit from a reasonably favourable rate of tax on any growth it might achieve. Of course, to eventually get it out of the business you’ll have the same challenge as always! I just realised I have yet to do a piece on this – it’s on the list!

d) Reliefs: Again, any company big or small in the State can be eligible for the various reliefs available – whether on sale or wind-up of a company. The primary reliefs of interest in business exit are Severance Payments, Entrepreneur Relief and Entrepreneur Relief.

Pensions For Business Owners – Pitfall #1, Death In Service:

One of the biggest threats to your overall planning within pensions is Death In Service. The reality is that if you are a member of an Occupation Pension Scheme and you die while being an ‘active member’, Revenue determine how the benefits can be paid to your estate.

Many people do not realise that Revenue rules currently dictate that the Trustees of your scheme to pay out a lump sum of four times your salary, and the balance of your pot at that time must be used to buy an Annuity. This can be a major issue if you are an active member, if you have not preserved your scheme assets and/if your scheme assets are valued at vastly more than four times your salary.

Solutions to Pitfall #1:

Many Directors that I have met have multiple pension schemes related often to multiple employments. It can often be the case that some schemes they have relate to past employments etc, which of course fall outside the ‘4-times salary net’, and will therefore usually be paid in full to the estate.

In instances where you do have scheme benefits related to your current employment that are much higher than four times salary, here are some potential separate options to remove this very negative potential outcome of having to buy an Annuity:

  • Wind-Up scheme benefits and transfer to a Personal Retirement Savings Account (PRSA) – This is only possible in certain circumstances and situations. For example you need to be in ‘pensionable employment’ with the company for less than 15 years, and your scheme must not be ‘over-funded’ to do this. Like anything, there are pros and cons of doing this, but it can be an effective way to try to preserve the scheme benefits, as PRSAs are paid out in full to the estate irrespective of the four times rule. Please note that many advisors suggest that transferring your scheme to a Personal Retirement Bond (PRB) or Buy Out Bond (BOB) will preserve your scheme however technically, if you transfer to a PRB/BOB and are still an employee, the benefits are not formally preserved and may fall into the 4-times salary PLUS annuity net.
  • Terminate Pensionable Employment: There can be a bit of red tape involved but this is basically notifying the Pensions Authority and Revenue that the company will never put in place a pension scheme for you. It formally ‘preserves’ the scheme for you so that it would be paid out in full to your estate, but it does mean if the company ever put a pension (or indeed company-linked protection plan) in place on you again that they would no longer be preserved!
  • Leave Employment: If you cease to be an employee, you cease to be an ‘active member’ of the scheme and therefore all benefits paid out in full to your estate, usually.
  • Increase Your Salary: This is something that many business owners are slow to do of course (many of us are allergic to paying more tax than we need to!)
  • Pass Your Normal Retirement Age (NRA): Revenue and Pension’s Authority recently confirmed to me after some investigation that if you pass your NRA but remain as an employee, the scheme is preserved – and so paid out in full if you were to die.

Please note that the above is not exhaustive. The optimal route to take to mitigate the 4-times rule is a very nuanced and technical aspect of planning that needs proper investigation, planning and execution. Don’t jump into something without having total clarity on the consequences and implications.

Pensions For Business Owners – Pitfall #2, Under-Funding

As mentioned a little earlier, Revenue allow any company, large or small, to build up a retirement pot for it’s employees. In PAYE world, that usually means that they will contribute 5% or 10% of salary or whatever. In the case where you own the company, where you are a Director, you can instruct the company to maximise the allowance the Revenue allow.

And that allowance means that an employer, subject to you having sufficient level of earnings and service from that employment, can potentially build a pot that would theoretically generate up to 2/3rds your final salary. The amount that is allowed to be contributed is calculated based on an actuarial calculation. In this Revenue Calc they actually assume certain annuity rates and growth rates meaning the funding allowed now is hugely flexible and will change as you get within 5 years of your NRA!

Interestingly, based on your salary and service, Revenue will allow your company to actually build a pot that far exceeds the Standard Fund Threshold (in which case Revenue will benefit massively by hitting you with a saucy Chargeable Excess Tax. Check out Blog 151 for a deeper dive on SFTs and Excess Tax.

Anyway, if you have a ‘successful’ business and are have the potential to be maximising the opportunity, but aren’t aware of it – this one is hopefully of use to you and worth exploring. If you are ‘under-funded’ don’t panic, there is usually scope to make up for lost time by making ‘One-Off’ contributions and still plenty of time to claim the valuable tax reliefs available for your business.

Pensions For Business Owners – Pitfall #3, Over-Funding

This is probably the least common occurring of the three pitfalls noted in this piece – however it is probably the most dramtically negative in financial terms. If your scheme is of a higher value than it ought to be in Revenue’s calculation when you go to draw down benefits it’s not good.

Your scheme can become over-funded due to one or a combination of the following. Worth noting that quite often you can do some or all of the following and it not result in an Over-Funding Issue – but these are some of the things that can cause an over-funding:

  • Your scheme on draw-down has higher value than your salary/service warrant per Revenue Calcs
  • Contributions to the scheme were higher than they should have been
  • Growth on your scheme was far in excess of the growth assumed in Revenue Calculations
  • You take benefits from your scheme far earlier than your Normal Retirement Age

Again, if you are thinking about doing some of the above, know that many business owners have done many of the above and still not been over-funded, but these are the things that can potentially cause such an occurrence. Pensions for business owners is a balancing act sometimes but usually an over-funding doesn’t occur unless you are being reckless.

Simply put, the solution for avoiding an over-funding is to ensure that you operate within Revenue rules in terms of your contributions. That’s the element we can control, and is the determining factor in vast majority of cases.

Pensions for business owners possess great opportunity:

  • Tax efficiently take money out of your successful business
  • Achieve tax-free growth within the pension itself
  • Put money aside for future use and retirement incomes
  • Provide a margin or error in becoming financially independent and walking away from ‘working life’ when you want to
  • Deliver great peace of mind to you knowing that these funds are separated from the business, no matter what!

Charlie Munger talks about intelligent people making decisions based on opportunity cost. (Here’s an 8 minute clip from 1997 Berkshire Hathaway AGM where himself and Warren B talk about Opp Cost).

I guess pensions for business owners are an example of something where the opportunity can be worth multiples of the cost – provided we avoid potentially nasty pitfalls. You’ll obviously want it to be a case of ‘all duck’, as opposed to ‘no dinner’!

Paddy.

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