While auto-enrolment is a net positive outcome for employees in Ireland (because it’s clearly better to have a pension than to not) there are some downsides of participating in the Irish pension system using auto-enrolment.
To reiterate, the downside is not pensions themselves, but rather Ireland’s proposed system for auto-enrolment. Firstly, there’s the taxation treatment. As was noted by Sage, employee contributions to their auto-enrolment pension will be taken from net income after income tax, USC and PRSI have been accounted for.
This is different to how employee pension contributions are normally treated whereby there’s an exemption from income tax but not USC and PRSI. So which system is better?
Let’s say we have an employee who is earning above €42,000 which is the threshold for the higher rate of Irish income tax of 40% after Budget 2024.
Under auto-enrolment, a net contribution of €60 by the employee would result in a further €20 being invested by the Irish state (i.e. €1 for every €3 invested). This means that the effective gain realised as a result of the Irish state’s participation is 33% (i.e. (€80 minus €60)/€60).
In the case of a non-auto-enrolment pension contribution, we can view the ‘Irish state’s participation’ as the income tax exemption which is afforded to pension contributions. In this case, a “net contribution” of €60 for our higher rate taxpayer would be the same as a gross contribution of €100, with the difference being the €40 that is saved by not having to pay income tax at 40% on €100.
In this case, the effective gain realised as a result of the Irish state’s participation is 67% (i.e. (€100 minus €60)/€60). Therefore, on a pure taxation basis, participating in the pension system via auto-enrolment is less favourable to higher rate taxpayers than self-participation.
For standard rate taxpayers (i.e. those paying income tax at the lower rate of 20%) the position is different. A “net contribution” of €60 for our standard rate taxpayer would be the same as a gross contribution of €75, with the difference being the €15 that is saved by not having to pay income tax at 20% on €75. In this case, the effective gain realised as a result of the Irish state’s participation is 25% (i.e. (€75 minus €60)/€60).
Therefore, on a pure taxation basis, participating in the pension system via auto-enrolment is more favourable to standard rate taxpayers than self-participation. However, when you account for the fact that employer matching is mandated under auto-enrolment, the less favourable taxation treatment for higher rate taxpayers can actually be mitigated to some degree.
This is because if a higher rate taxpayer was to set up PRSA, while they would get income tax relief at 40% on contributions, their employer would not be obligated to contribute to their PRSA. So the net outcome of using a PRSA could actually be worse despite getting better tax relief. However, this is entirely dependent on contribution levels and that brings us to the second downside of auto-enrolment, contribution limits.
As has been made clear by the Irish Government, employee contributions under auto-enrolment will be fixed according to the specified rate schedule over the next 10 years and, as a result, employees won’t be able to contribute less or more than the set rate at a given point in time.