Wednesday 4th August 2021
This debate is somewhat unique to Ireland. We are a country with 50% tax rates that kick in pretty early on in one’s personal income, but we also have exceptionally generous pension schemes - especially if you are self employed.
In this article, I explore the concept of investing in property personally VS investing in a pension, to work out the fastest way to become FI in Ireland.
We are going to make several assumptions in this article, which are listed below. The biggest being that these figures have been applied to someone who is self-employed.
This is because self-employed people in Ireland can set up their own company and through that access a Director’s Pension, which typically allow a company director to make huge pension contributions - far greater than the 20% or so that is available for PAYE earners in their 30’s. Director Pensions allow for a 100% contribution, meaning that there is no tax applied on any contributions.
This isn’t to say that this won’t work if you are a PAYE employee, but you may need to adjust the assumptions to suit.
Finally keep in mind that any profits in a pension grow tax free in Ireland, whereas any rent profits in Ireland will be taxed at the margin tax rate - which for most will be 50%.
Of course, the big downfall of pensions is that they can’t be accessed until one is at least 50. This may change to 55 in future years, though my financial advisor does tell me that even if it does, the pension could be set up with a retirement age of 50, so there is a potential work around. Time will tell, but this should be kept as a consideration.
We should also be aware that laws with investment properties are always changing and typically tenants rights are becoming better, which is usually bad for a landlord if you get a tenant that refuses to pay rent. Some countries are also phasing out the ability for interest on a mortgage to be tax deductible, so if there are changes here this could be significant. Furthermore, a recent law was changed which has limited the amount that rent can increase in many areas in Ireland by the inflation rate - somewhere around 2% per year - so this should also be kept in mind.
I thought I would start by giving my gut feeling. I've always seen 50% tax in Ireland as a real barrier to any early retirement potential, so for me a pension with a 100% tax free contribution, growing with tax free returns will be a better investment than paying 50% tax and further paying 50% tax on any profits. Even though a pension can't be accessed until one is in their 50's or 60's, it is likely still a faster path to FI in Ireland.
Let's make up a story! We will assume that we have a friend called Steve. He has no debt and has no investments at the moment.
Steve is employed as a PAYE worker, but he is considering buying property personally VS investing via a pension. Steve is in IT and has the option to start contracting, which would allow him to set up a company and access a Director’s Pension.
Steve is 35 years old and we will assume he has an additional €40,000 a year in which to invest, pre tax.
Effectively, Steve is tossing up between two options. The first being to invest €40,000 per year into a Director’s Pension, the second being to take the tax hit and pay tax at 50% to save €20,000 per year to buy investment properties.
Steve has worked out that he will need €30,000 per year in retirement in today’s money.
We will assume inflation will run at 2% per year when calculating his FI number.
We will use the 4% rule, meaning that Steve will need a portfolio or property value of €750,000 in today’s money to retire.
Alternatively if Steve is able to generate cash flow of €30,000 per year from property, he could also retire. With the property route, he has the option to either live off the cash flow from rent, or sell the properties once they hit his FI number.
Steve will be able to set up a Director’s Pension with Davy Select and can purchase a mix of individual shares, index funds, ETFs, REITs and Investment Trusts. Steve expects to receive an annual return of 6% after fees from his pension.
Steve will be able to invest €3,333.34 per month (€40,000 per year). Any gains will continue to compound tax free. We will assume that Steve will make a 6% yearly return from his pension - this is a 4% real return after 2% accounted for inflation.
Once Steve hits his FI number, he will be able to withdraw 4% per year from his pension to cover his expenses. Note - Steve will also be able to withdraw a one off tax free amount of up to €200,000.
We will assume Steve will purchase property for €200k, with a 7% gross yield from rent. We will assume the interest rate on any property is 4%.
We will assume that after property management fees, repairs and maintenance, insurance, property tax and any unoccupied periods, that Steve receives 80% of the rent as income.
We will assume that property in Ireland will grow at an annual rate of 6% and that rent will increase by 2% per year, in line with inflation.
Any profit from rent will be taxed at 50%.
I won't factor in legal fees, stamp duty and any other purchasing costs to keep things simple. We will assume Steve needs €60k to purchase each property and will borrow €140k.
We will start by crunching the pension numbers and then see if he could reach FI by age 50. We will then see if he could reach FI faster if he chooses the property route.
The most common reason people don’t use a Pension in Ireland, is because they tell me that they plan to retire before the pension age. I guess it somewhat depends what age you start your FI journey, but let's see if this is true for Steve.
Steve is currently 35 and is hoping he can retire by the time he is 50. Before we go and assume Steve needs to build a pot of €750,000 to hit his FI number, let's remember to factor in inflation.
We use the trusty Compounding Interest Calculator, and you can see the results here.
Effectively at 2% inflation, €30,000 in 2021 will be the same as €40,000 in 15 years time. When we multiply this by 25, we end up with a FI number of €1,000,000.
So, will Steve get there in 15 years? Assuming Steve contributes €3,333.34 a month and gets an average annual return of 6%, then after 15 years he will have a portfolio of €956,374.92. He will be short of his goal - but not by much. Infact, within 6 months of that date, he will have hit his FI number and can retire - you can see the workings here.
Therefore, Steve will be able to retire at age 50.5 and within 15.5 years saving €40,000 per year in a Director's Pension.
Of course, we can’t say what the market will actually do over that 15 years, but this is why making assumptions can be fun!
One nice thing about pensions is that they are super easy to show the year by year breakdown and it is pretty easy to forecast!
OK, so here is the million euro question - can we get there faster with property.
When I first drafted this, I looked to break down year by year. I figured Steve would be able to buy 3 or 4 properties in 12 years or so (one every 3 years). The figures got super complex and it was just so confusing - after I got to year 10, I gave up - I can tell you that this approach was far less than the pension, and it didn’t look like Steve would hit FI before 50.
I also want to point something out that I found out every year working through the numbers - and I have recently found this out about my own rental property - when you pay 50% tax on rental income, rental income in Ireland likely won’t produce positive cash flow. That is, after you have paid tax on your rental profits, there likely won’t be any money left over - in fact most of the time you will be left needing to add cash yourself to cover the mortgage.
Your tenant will pay down the mortgage - don’t get me wrong, they will still pay off your mortgage for you - but you won’t be left with much after that!
Here is an example that I had from the numbers above from year one of Steve’s first property:
|Rental Income (80%)||€11,200|
|Tax Due (50%)||€3,058.55|
Seems like a profit right, but there is also another €3,045.78 of mortgage payments due (the capital allocation from the mortgage repayment) - I only counted the interest in my profit and loss above. It quickly becomes clear how guys like Robert Kiyosaki make property produce cash flow - he is likely taking on an interest only mortgage - but in Ireland that typically isn’t an option - and Robert likely isn’t dealing with 50% tax rates!
Every year was pretty much the same - as I mentioned, most years produced a negative cash flow. Yes, equity was growing - but there wasn’t any cash flow out of this process.
It quickly became clear that there were only two ways to make property work for Steve.
For this approach to work, Steve will need to buy 3 properties and look to pay off the mortgages as quickly as possible to live off the rental income (paying 20% on profits inretirement rather than 50%, as he won’t have any other income). With the rental income after expenses being around €11,200 per year in today’s money, he would need roughly 3 properties to produce an income of €33,600 per year. Obviously the rent will increase every year, but only inline with inflation.
It has quickly become clear that the recent law change in Ireland that rental properties can only increase rental prices inline with inflation pretty much rules out retiring within 15 years from taking this approach. If you want to try and work it out, go ahead - I did already and you will quickly see there is no way Steve could pay off 3 mortgages within 15 years with only an additional 20k coming in per year. We are talking about trying to clear €420k of mortgages within 15 years. Keep in mind, Steve will need a deposit of €60k per property, so already €180k has gone on deposits alone. This will leave €120k of additional income to try to pay €420k - the numbers just don’t work - yes, the tenant will pay down some of that capital, but not nearly enough. If Steve was 25, I suspect this might work - but even then, it would be likely in his late 40's or early 50's before he retired.
This seems a far better option. Basically, Steve builds capital on the properties and looks to sell them in retirement. He then invests the capital in equities and applies the good old 4% rule.
Capital gains tax will be due on any sale in this case, so it's a bit of a double whammy - 50% tax paid to get the capital in the first place, then 33% tax paid on any capital gains made.
We can work this out pretty easily - here is what we need to assume:
We know that Steve will need 3 years to save up €60k for the first property. So, he will buy the first property in year 4. Let’s assume that Steve plans to sell the property in year 15 - so we have 11 years of capital growth.
For property two, he will purchase that in year 7, so he will have 8 years of capital growth.
He will purchase property three in year 10, so he will have 5 years of capital growth.
Lets also assume Steve buys one more property at year 13, with 2 years of capital growth.
To keep things simple Steve will buy each property for €200k, with a 60k deposit. I am aware that this doesn't fully make sense because property prices will rise, but we will assume they will rise with rental yields, and as such, Steve can continue to buy €200k properties, albeit in different locations and different sizes as the years go on.
I have worked out the mortgage balances at year 15 for each property. The idea is simple - Steve will need at least €1,000,000 in equity from the four properties to beat the pension. Infact, he will need more than that - as he will need to pay capital gains tax at 33% on any capital gains - a huge disadvantage of this approach.
Before I even try to calculate this, let's see if Steve gets anywhere close to having €1,000,000 in equity by year 15 - if he does, I will deal with the capital gains aspect.
For transparency, you can see the repayment calculator I used to break down the repayments.
For each property, I used:
Loan Amount 140,000
Interest Rate: 4%
Years: 25 (this is the standard for a buy to let)
Start Date: 1/1/21
Here is the breakdown of the four properties at year 15:
|Property 1||Property 2||Property 3||Property 4|
|Original Purchase Price||€200,000||€200,000||€200,000||€200,000|
|Years of Capital Growth||11 Years||8 Years||5 Years||2 Years|
|Valuation at year 15 (6% annual return)||€379,660||€318,770||€267,645||€224,720|
|Mortgage Balance at year 15||€95,362||€109,625||€122,278||€133,502|
There is one factor I needed to consider as well, which is that Steve will purchase his last property in year 13, so he will have an additional €60k which he could use to pay down the mortgages a little faster. I won’t work out the exact interest that he will save (it would be minimal), but roughly the total equity can be defined as:
|Additional Cash / Repayments||€60,000|
So there we have it. If Steve goes all in on property, he won’t get anywhere near the €1,000,000 mark by year 15 - and I haven’t even factored in the capital gains tax he would need to pay on the sale of the properties.
Working out property strategies is hard and I have had to make a lot of assumptions here. If you are able to find a better way for Steve to structure these investments, then please do let me know - I was unable to find a way for Steve to find a path to retirement in less than 15 years with property.
If you are in your mid 30's and have access to a Director's Pension or Pension that allows you to retire in your early 50's, it is simply better to invest via a pension in Ireland. 50% tax rates make any other path nearly impossible.
I have made a HEAP of assumptions in this article, and I am well aware that we can’t predict the future and that different assumptions might yield different results - however based on these very reasonable assumptions, there is one clear winner!
If you are pro property then there is always the option to purchase it within a pension if you are self employed, or alternatively purchase directly from a company rather than personally. I haven’t done the figures, but I know that within a company there are some complex tax laws, and as we have seen from the figures above, as soon as tax comes into the equation, it makes things complex and is unlikely to beat a pension.
Buying a property within a pension is likely a good idea. It will limit the exposure to 100% equities and give some stability long term. I know this is getting harder and more difficult to do - but it is possible. I should point out, Property is clearly a good investment - but its made difficult with such high tax rates.
Tragically, for those actively trying to pursue FIRE in Ireland, this is just more proof that early retirement for most of us in Ireland just isn’t an option - we are somewhat forced to take the pension route as it is simply the most viable path to FI.