WTF is an ARF ?!!
Updated: Mar 31, 2022
An ARF is something to do with retirement ?
An ARF is an Approved Retirement Fund. When you hit retirement age, 65 for most, people have a lump sum value in their pension fund. A fund has invested - into shares but also into bonds and property - all the contributions you have made over the years. Hopefully the fund has done a good job and multiplied by many times the amount of contributions you have made.
The first benefit relates to the money we pay into them - our contributions. Instead of paying tax on our salary, we can elect that we invest a portion of our salary (before tax) into our pension fund. Secondly, once our investment is in a pension fund it grows with no income tax, DIRT or capital gains tax. This helps the snowball effect of fund growth.
And the last benefit brings us nicely to our choices at retirement.
What can I do with my pension fund when I retire ?
Most clients elect to avail of the third tax advantage. This is the ability to take 25% of the value of their fund as a cash lump sum. With a current pension fund size limit of €2,000,000 ("standard fund threshold") this cash lump sum can be up to €500,000. Before the Celtic tiger bubble burst, pension funds were permitted up to the value of €5,000,000 !
The first €200,000 of the cash lump sum can be taken completely free of tax. The balance can be taken at a 20% tax rate.
What about the rest of the pension fund ?
After you have taken your cash lump sum, you have a choice to make. Traditionally, the balance of the pension fund was used to buy an annuity. An annuity is a guarantee to pay a fixed income for the rest of your life. It is a bit of a bet on your own longevity. If you think you will live to a hundred, this may be for you ! However, if you die shortly after your retirement date, your pension fund will effectively have gone up in smoke.
(Some people may choose to mitigate this somewhat by purchasing an annuity with a certain guaranteed period - e.g. 5 or 10 years. This means income will continue to your estate after your death.)
Another aspect of annuities that we have written about is it's relationship with interest rates. Effectively, the higher interest rates are, the bigger an income your pension fund will buy for you. With nearly fifteen years of ultra-low interest rates, annuities can seem poor value.
And this is where the ARF comes in ?
Getting a cash lump sum is crystallising your pension fund at the date of your retirement. A portion of your fund is sold at that date to raise the cash. A similar thing happens when you elect to purchase an annuity. You are thus exposed to market conditions at that time.
For example, we have seen drops of 20%, 30% and 40% to equity indices at various points over the past 15 years. However, as discussed above, the level of prevailing interest rates for judging the annuity option, is also critical.
An ARF is another fund - like your pension fund. So you can delay the moment of crystallisation for now. It is almost like kicking the can down the road. For example, if 10 years after your retirement, annuity rates increase, you can elect to purchase an annuity at that stage. This flexibility is appealing but it works best for those who follow the financial market evolutions very closely - either by themselves or in conjunction with a financial broker like AM Financial.
An annuity pays me income in my retirement - how does the ARF alternative work ?
The choice of withdrawal is up to you. For example, perhaps in your first year of retirement, you wish to have an income of €40,000. The withdrawal is subject to normal income taxes, USC and PRSI.
As there is no employment income at this time, the average tax rate will work out lower than if this income had been taken during one's career.
And if I don't want to withdraw, can I leave the fund as it is
You can but the tax system prompts you to withdraw at least 4% per annum. This is because there is an imputed tax to your ARF. You are taxed assuming you took 4% out of your fund - even if you don't withdraw anything. The amount of imputed tax is deducted from your ARF. For this reason, most people elect to withdraw at least 4% every year.
And what happens to my ARF if I live forever !
Unlike an annuity, an ARF will not last forever. If we start with €1,000,000 and we withdraw €50,000 every year, it might seem like this can only last for 20 years. However, the money that remains in the fund will (more than likely, although not guaranteed !) continue to increase in value. So this will give us longer than the 20 years.
It is the interplay between the withdrawal rate and the return on our ARF that will determine how long it lasts for. Good financial advice will keep you on top of this.
And what happens if I die shortly after retirement.
An annuity (without a guaranteed period) will stop paying income on your death and it effectively extinguishes.
Another reason that many clients elect for an ARF is that it does not extinguish - it passes to your next of kin upon your death. It passes free of income tax and free of inheritance tax to your spouse / civil partner. It becomes a "second ARF", and upon the death of your spouse passes to your children. For children over 21, a 30% income tax applies and no inheritance tax. For children under 21, inheritance tax but no income tax applies.
An ARF allows preservation of wealth within the family.
And that's it folks
At all stages in the retirement journey - setting up a pension fund, preparing your choice at retirement age and managing your retirement income - good advice is crucial.
AM Financial is your financial broker in Dublin. Contact us and we will discuss your situation in confidence.