Key Post Should a person in their 20s or 30s contribute to a pension?

Brendan Burgess

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This is based on the current pensions and tax regime. This regime will change before you reach retirement

  • Tax relief on pensions may be changed to 30% for everyone. If you are paying tax today at 40%, then you will lose out if you defer contributions to a time when the tax relief is reduced to 30%. On the other hand, if you are paying tax today at 20%, you would be better off deferring contributions to a time when you might get tax relief at 30%.
  • At present you can build up to a fund of €2m tax-efficiently. Anything over that is taxed at a penal rate. This limit might be reduced or increased.
  • Pension funds accumulate tax-free, but a FG minister imposed a levy on pension funds. If it has happened before, it could happen again – especially with a left wing Minister for Finance.
As the future tax regime and as future investment returns are uncertain, there are no definite answers, just guidelines.

Here are the key questions this post will address:
  • Should you delay buying a house to start a pension or should you delay starting a pension to buy a house?
  • Having bought a house, is it better to use any available savings to contribute to your pension or to pay down your mortgage?

Why contributing to a pension is usually a good idea

  • You get tax relief at your top rate of income tax on your contributions
  • The fund grows tax-free
  • On retirement, you can take around 25% tax-free.
  • While you pay tax and USC on what is left after the tax-free lump sum, your top rate of tax then may be lower than the rate you are paying now.
If you are in your 20s or 30s, it might be better to postpone making contributions and save for the deposit on a house or reduce your mortgage
  • You cannot access your money until you retire
  • You might need the money sooner to get on the housing ladder or cut your debt
  • If you are paying tax at 20%, then you will get only 20% tax relief. You might be better off waiting until you are earning enough to get tax relief at 40%.
  • You do not want a situation where you get tax relief at 20% but end up paying tax and USC at 45% when you draw it down in retirement.
If you are likely to squander the money instead of saving for a house, then you should contribute to a pension.

It may be better to save outside a pension scheme but if contributing to a pension is the only way to force you to save, then this would be a more important factor.

If your employer matches your pension contribution, you should max your contribution

For example, if you contribute 5%, they contribute 5%. If you contribute nothing, they contribute nothing.

It is always right to max your contributions to the level of your employer’s contributions in this situation.

Factors arguing for maxing your contribution now

  • You are paying tax at 40% on your income
  • The 40% tax relief may be reduced to 30% in the near future
  • If you don't use your annual contribution limit, you will lose it
  • You have already bought your home and your mortgage is down to a comfortable level
  • You don’t intend trading up for some time
  • You do not have any other expensive borrowings
  • You have no other intended expenditure
  • You are closer to 40 than 20 – because you will have less time to utilise your maximum contributions
  • You have a very small pension fund because you were a late starter
Factors arguing for deferring pension contributions until later

  • You are saving for the deposit on a house
  • You are in danger of going into arrears on your mortgage
  • You have an uncomfortably high mortgage
  • You have a house and a comfortable mortgage but you are planning to trade up
  • Your mortgage is approaching one of the LTV trigger points. For example, bringing your mortgage from 81% LTV to 79% LTV might get you a lower rate on your entire mortgage.
  • You are not earning enough to pay 40% tax
  • You have no taxable income
  • You are closer to 20 than 40 – you have plenty of time to “catch up.”
  • You already have a very large pension fund
Why saving for a deposit is a higher priority than contributing to a pension fund

Both are forms of long-term saving.

It is generally cheaper to pay a mortgage than to rent, so the earlier you can get on the housing ladder the better. Even if you think that house prices are going to fall, you should still save up for a deposit, so you can buy when house prices fall.

Having a bigger deposit has huge advantages

  • You get on the housing ladder earlier
  • It will be easier for you to get a mortgage
  • You can buy a bigger house. It is better to buy your “second” house now, rather than to buy a starter home and then trade up after 5 years.
  • The higher your deposit, the lower will be your Loan to Value Ratio. The lower the LTV the lower the mortgage rate – on your entire loan.
Why overpaying an uncomfortably high mortgage is a higher priority than contributing to a pension fund

Many people take out uncomfortably high mortgages to get on the housing ladder and that is fine. But your priority should be to pay it down to a more comfortable level as quickly as possible.

  • You are less likely to fall into arrears, if things go wrong.
  • When interest rates rise, you will not be as badly affected
  • If your income falls or you lose your job, you will find it much easier to reschedule your mortgage
Staying out of arrears is really important. Having a clean credit record means that you can switch to another lender if there are better deals available and it means that you can borrow again in the future, for example, if you want to buy a car or trade up.

  • If you can bring the LTV below 80% you can get a lower mortgage rate.
  • If the mortgage rate is 3%, paying down your mortgage is the equivalent of getting a guaranteed, tax-free return of 3% on your investment. It is also charges-free.
  • If you want to trade up, having plenty of equity in your home, makes it easier
  • And, of course, you will pay off your mortgage earlier. After you have cleared your mortgage, you will be able to contribute more to your pension fund.
What is a comfortable mortgage?

There are two measures of comfort – Loan to Income and Loan to Value

A comfortable mortgage in relation to your income is a level which allows you to handle a rise in mortgage rates or a drop in income - for example, if you want to take unpaid leave.

A mortgage of €300k would be uncomfortably high for a couple earning €50k each, but quite comfortable for a single person earning €100k.

A young person starting off their professional career who has reasonable expectations of significant salary increases would be able to tolerate a higher LTI. This is why many lenders give young solicitors and doctors exemptions from the LTI limits.

The LTV is a lesser consideration, but still a consideration. If property values fall, you may go into negative equity and would be trapped in your home unable to trade up or move location. And, as pointed out earlier, high LTV mortgages usually have higher mortgage rates on the whole loan.

So you should target getting your LTV down to 80%.

If you are thinking of trading up

If you are living in a one bed apartment with a young child, your absolute priority will be to trade up. As a second time buyer, you will need a deposit of 20% of the price of the house you want to buy. So you will need to have this either in equity in your existing property or in savings. So you should not be making unmatched pension contributions.

If you are thinking vaguely that you might like to trade up after a few years, but you have enough equity in your home to fund the 20% deposit required, then having access to your savings is less a priority.

There is a risk that the 40% tax relief might be reduced in a future Budget

At the moment, you get 40% tax relief on your contributions if you are paying at the top rate. This might be cut to 30% in which case you will regret not having contributed more at 40%.

“But if I don’t use my contribution limit this year, don’t I lose it?”

In your 20s, you can contribute up to 15% of your salary to your pension fund up to a maximum of €17,250 each year. If you don’t contribute this year, you lose that opportunity. In your 30s, the limit is 20% and €23,000.

I don’t see this as a major issue in your 20s and 30s. If you have focussed on getting the deposit together and paying down an uncomfortably high mortgage, your mortgage repayments in your 40s and 50s will be lower than they would otherwise have been leaving you space to utilise the maximum pension contribution limits then.

So maybe you should strike a balance between pension contributions and overpaying your mortgage

The big risk is that tax relief might be reduced from 40% to 30%. So even if your mortgage is a bit high, maybe contribute something to your pension fund and overpay your mortgage a bit as long as you have a plan to get your mortgage down to a comfortable level in the short to medium term.

If interest rates rise or if your job or income looks less reliable, then maybe pay more off your mortgage. If you are a public servant with a secure job, then maybe swing towards your pension.

If you are paying only 20% tax relief, you should not be making unmatched pension contributions in your 20s or 30s

  • Your salary may well increase and you might be able to get 40% tax relief on it in the future
  • Even if your salary does not increase, there is talk of giving everyone 30% tax relief on their pension contributions irrespective of their tax status so you would be better off if you delay contributions to that date.
  • 20% tax relief and tax-free accumulation is just not enough compensation to lock up your money for up to 30 or 40 years
  • If you are paying 20% tax, you are on a low income, and contributing to a pension might not be your priority.
Can you have too much in your pension pot in your 30s?

Any balance in your fund in excess of €2m on retirement, will be taxed at punitive levels.

If you have a pension fund of €500k at 40, it could easily rise to €2m by retirement, even without any further contributions.
 
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RedOnion

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If you are in your 20s or 30s, it might be better to postpone making contributions

  • You cannot access your money until you retire
  • You might need the money sooner to get on the housing ladder or cut your debt
This is all perfectly rational, but misses a key behavioural aspect that affects a lot of people.

When I was in my 20's, I wasted all my money. I think if you're a high earner, and not savings for something specific, a pension contribution removes that temptation to waste money.

I had about 6 years in my mid 20's earning over 60k and not contributing anything material to a pension (just the minimum 2 or 3%). I could have put over 40k into a pension in those years all at higher rate relief, and still had a very high standard of living (just less drinking!)
 

Alkers86

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Very interesting post, would have thought it would have been a lot more clear-cut for paying into the pension.

I am 32, maxing my pension contributions (employer 7% or something like that so making another 13% on top of that myself) and my partner is something similar, we own a house but are probably just above the 80% LTV currently and ideally would like to trade up in the next few years. Will have to re-evaluate our contributions, although we both didn't start our pensions until 5-years ago and our salaries have only significantly increased in the past couple of years.

You talk about large and small pension funds in the original post, is there a metric that could be used to judge this or is it subjective?

Also, I would have thought most people who bought since the central bank limits came in would have comfortable mortgages? The LTI limits result in very manageable monthly repayments, certainly in comparison to the cost of renting. I would like to hear the logic behind you considering a €300k mortgage to be uncomfortable for a couple earning €50k each? We earned €39k and €41k when we got an LTI exemption to borrow just over €300k and the repayments were always comfortable. Our gross earnings have since increased over 60% as we were both relatively junior in our careers at the time.
 

Gordon Gekko

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There an obvious argument for neglecting one’s pension if it facilitates the purchase of a home.

However, by neglecting one’s pension in the early years, there is less time for the contributions to compound tax-free.

And the “use it or lose it” nature of tax relief prevents employees from catching up on lost years in the manner that a company owner can.
 

Brendan Burgess

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Hi Alkers

As Red points out buying a house can be a great fertility treatment.

If one of you takes unpaid leave, you will have a mortgage of €300k on a salary of €64k. That is way too high.

But you have made an excellent point about prospects for salary increases which I will incorporate into the first post.

Someone starting off their career who expects salary increases can obviously live with a much higher LTI.

Brendan
 

Brendan Burgess

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by neglecting one’s pension in the early years, there is less time for the contributions to compound tax-free.
Yes, but your mortgage savings are compounding tax-free as well.

And if it allows you to buy a house earlier, it's probably increasing in value tax-free also.

Brendan
 

Brendan Burgess

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You talk about large and small pension funds in the original post, is there a metric that could be used to judge this or is it subjective?
The maximum tax-efficient pot at 65 is €2m. Over this, and you will pay punitive tax.

So €500k at age 40 is a big pot and no further contributions should be made.

€250k at 30 would be a max pot and no further contributions should be made for a few years.

A pot of €100k at age 30 would be a good pot and you would not need to worry about the use it or lose it rule.
 

Brendan Burgess

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are probably just above the 80% LTV currently and ideally would like to trade up in the next few years.

Which lender are you with? You should probably bring it below 80% and see if you get a better rate on the entire mortgage!

If you might want to trade up, then I think your priority should be to pay down your mortgage until you get equity equal to about 20% of the price of the house you want to buy.

Brendan
 

Brendan Burgess

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I think if you're a high earner, and not savings for something specific, a pension contribution removes that temptation to waste money.
OK. I will edit the post to say that saving for a deposit is better than saving for a pension. But saving for a pension is better than squandering the money.

I suppose the attraction of the pension is that you can't touch the money.

Brendan
 

NoRegretsCoyote

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Factors arguing for maxing your contribution now

  • You are paying tax at 40% on your income.
  • You have already bought your home and your mortgage is down to a comfortable level
  • You don’t intend trading up for some time
  • You do not have any other expensive borrowings
  • You have no other intended expenditure
  • You are closer to 40 than 20 – because you will have less time to utilise your maximum contributions
  • You have a very small pension fund
The very, very important point you are missing is the powerful nature of compound interest over a human lifetime.

Assume a 3% real return. You start working at 25 and retire at 65.

Every €100 you put in at 25 turns into €325 by retirement. Every €100 you put in at 45 turns into only €181 by retirement (both inflation adjusted).


Yes, you will have lots of other financial commitments in your 20s and 30s. Buying house is indeed a very tax-efficient investment vehicle.

But I would urge everyone to pay at least a small amount into their pension as soon as they are in any kind of stable employment.
 

Sarenco

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Another very significant issue is the variability of investment returns.

To achieve long-term equity returns you have to invest for the long-term. That means decades - not years.

Just look at the first two decades of this century - equity returns in the first decade were basically flat but stocks have been on a rip this decade.

The €2m fund threshold is a red herring, IMO. It's easily managed.

I understand Brendan's take on this issue but frankly I think he's flat out wrong.
 

Investadvice

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The maximum tax-efficient pot at 65 is €2m. Over this, and you will pay punitive tax.

So €500k at age 40 is a big pot and no further contributions should be made.

€250k at 30 would be a max pot and no further contributions should be made for a few years.

A pot of €100k at age 30 would be a good pot and you would not need to worry about the use it or lose it rule.
Can you share your calculation on this advice, re 500K at 40 and one should stop contributing?

You would need to make an average over 25 years of 6.5% interest, net of fees, to come to this amount. Say fees are 1%, you are talking 7.5% annually. Seems optimistic in the extreme.

Surely it would be better to keep on contributing based on an employer match you may get given its free money. If a 50 year old is in the lucky position of having say 1.5M after this then they could transfer into less risky investment types till they get to 2M and then move into cash?
 

Brendan Burgess

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The very, very important point you are missing is the powerful nature of compound interest over a human lifetime.
Hi NRC

The very, very important point you are missing out on is that loans attract compound interest as well. Paying off a loan at 3% a year, compounds at 3% a year.

If the availability of a deposit allows you to buy a house earlier, then you are getting the compound return on the house as well.

Brendan
 

Brendan Burgess

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To achieve long-term equity returns you have to invest for the long-term. That means decades - not years.
Hi Sarenco

Don't forget that I am suggesting that the person invests for the long term - but it's just via their home and via paying down their mortgage.

So they are in a market for the long-term.

So they are getting the return on property for the years that they are not invested in equities.

And as it happens, the returns for the first few years of pensions contributions don't matter that much - it's the returns in later years when you pension fund is bigger. Someone following my strategy will have as big a pension fund in the later years, because they will be contributing more.

Brendan
 

NoRegretsCoyote

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The very, very important point you are missing out on is that loans attract compound interest as well. Paying off a loan at 3% a year, compounds at 3% a year.
If you quoted my full post you would see that I accept that buying a house is a tax efficient investment vehicle.

I also mention real returns while you talk about nominal interest rates. If you allow for 2% inflation then a real return of 3% is a nominal return of about 5%.

Take a 40-something with a 50% LTV on a 2.8% rate, mortgage payments of 10% of net income. If she had spare cash I would advise her to put it into a pension rather than paying down the mortgage. A nominal return over 25 years of 5% is much better than the 2.8% nominal interest rate saving on the mortgage.

That's before you take account of tax relief and matching contributions.

And as it happens, the returns for the first few years of pensions contributions don't matter that much - it's the returns in later years when you pension fund is bigger.
This is simply wrong. The whole nature of compound interest is that the earlier you start, the bigger the eventual return.
 
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Brendan Burgess

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Can you have too much in your pension pot in your 30s?

Any balance in your fund in excess of €2m on retirement, will be taxed at punitive levels.

If you have a pension fund of €500k at 40, it could easily rise to €2m by retirement, even without any further contributions.
Hi Investadvice

I will rewrite this section as my point really was: It's very unlikely that you can have too much in your pension pot.

Gordon Gekko is reviewing his Key Post on this topic and as it will affect so few people, let's continue the discussion of this rare issue on that thread.

Should you contribute to a pension fund if you are in danger of breaching the €2m limit?

Brendan
 

Brendan Burgess

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The whole nature of compound interest is that the earlier you start, the bigger the eventual return.
But you are starting at the same time!

I have pointed out that starting a pension is better than squandering it. But for someone young, buying a house and having a comfortable mortgage is a higher priority.

Brendan
 
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