Let’s take an example. You are a sole trader in Ireland, aged 44, and you have profits of €100,000 (i.e. the amount left over after you have taken away all tax allowable business expenses from your revenue). Ordinarily, at this level of income, you would be subject to the higher or marginal rate of tax, which, when PRSI and USC is taken into account, is as high as 55% – over half of your income!
So, for simplicity’s sake, let’s estimate your tax bill at €55,000 (it would generally be lower than this, due to a portion of your income being at the standard rate of tax, and due to you being able to claim certain tax credits).
By mid-November of the current year, you will have to pay your tax bill of €55,000 PLUS your preliminary tax (see more about preliminary tax here) of another €55,000 to the revenue i.e. total payment of €110,000.
Now, let’s say that your accountant advised you to make the maximum tax-relieved pension contribution so as to increase your pension reserves while reducing your tax bill. In this case, the maximum tax relieved contribution works out as €25,000 (being 25% of your income for ages 40 – 49). You make the payment into your pension before end of October of the current year.
Your tax bill is now reduced from €55,000 to €41,250 i.e. a tax saving of €13,750. This is because the €25,000 is paid from your profits before tax, and your remaining profits of €75,000 is what is now subject to tax. Further, your preliminary tax matches your current year tax liability, and as a result you have a total payment to the revenue to make amounting to €82,500.
Taking the revenue payment plus your pension payment, the combined payment or cash outflow amounts to €107,500.
So, in short, you can pay €110,000 all to the revenue OR you can pay €107,500 split into €82,500 to the revenue and €25,000 into your own long-term pensions savings account. Cashflow-wise, the pension contribution makes a whole lot of sense.