Pension Funds and Taxation

With the passage of time, more and more pension funds are moving from a state-controlled pension fund regime to one in which pension funds are managed privately. Hence, every government needs a mechanism to promote investment in pension funds.

Preferential tax treatments are one of the most important ways in which governments can encourage people to appropriate more money for pensions.

Governments all over the world want to encourage more and more people to invest in pension funds and taxations are the most important tool at their disposal.

In this article, we will have a closer look at the common ways in which pension funds are taxed and the implications of such taxation.

Why the Subject of Taxation is Important?

It is important to note that the subject of taxation becomes very important when pensions are privately funded. This is because of multiple reasons. Two of the most common ones have been explained below:

  1. Firstly, when governments offer preferential tax treatments to pension funds, they are foregoing revenue in the present. Most countries around the world are running deficits. Hence, they are averse to foregoing revenue. However, they still do so because pensions encourage people to invest in their future.

    If more people invest in pensions today, they will become self-sufficient in the future. This means that the government will have to spend fewer dollars on welfare in the future. Hence, the revenue foregone today will be balanced out by lower welfare payments and the revenue earned in the future.

  2. However, there is a flip side. The government must equitably forego revenue in order to encourage investments. If the government offers a lot of incentives for people to invest in pension funds, it is likely that the rich will be investing more funds as compared to poor and middle-class people.

    Instead of becoming a tool for equitable distribution of taxes, the tax benefits provided to pension funds will start exacerbating the wealth inequality. The wealthy people will start using pension funds as tax-efficient investment tools.

Hence, when it comes to the taxation of pension funds, the government needs to tread carefully. If they offer too few incentives, people might not invest in pension funds at all. If they provide too many incentives, they may be misused by the wealthy. Governments need to be smart enough to understand how much is enough.

When can Pension Funds be Taxed?

In order to understand the policy around pension fund taxation, it is important to understand the various events when it is possible to tax the money in pension funds.

  1. Governments have the option to tax the money going into pension funds. This means that the payment being made to pension funds will be made with post-tax dollars.

  2. Once the money is invested in pension funds, it is invested in various securities. It is obvious that over a period of time, wealth is accumulated as these investments increase in value. The increase in value can also be considered to be an event when the government can collect tax revenue.

  3. Lastly, when the pension fund pays out benefits in the form of monthly or lump sum payments, this becomes income in the hands of the recipients. This can also be considered to be an event when the government can earn tax revenue.

In short, the government can either tax money going into the pension fund or it can tax money coming out of the pension fund. However, in most parts of the world, taxation cannot be undertaken both times. This is because if tax is collected twice, it will amount to double taxation i.e. taxing the same income twice.

Tax Levy Strategy and Trade-offs

Governments have to consider trade-offs before they can finally decide their tax levy strategy.

  • For instance, most governments in the world would like to levy taxes as soon as the income arises. This means that they would want the pension funds to be funded with post-tax dollars. However, in the absence of tax benefits, people are unlikely to lock up their money for long periods of time as is the case with pension funds. This is the reason that in most parts of the world, tax benefits are provided upfront to encourage more people to make the investment.

  • Now, if a government chooses the second option, then they have to forego the tax immediately. However, the investment grows at a certain rate. Once the investment is disbursed to the investors for consumption, the government can collect taxes on the same.

    Many experts claim that the tax owed to the government also grows at the same rate as the investment. Hence, the government does not face any tax loss. Instead, the tax payments are deferred and paid at a future date.

However, one also needs to take into account the fact that the tax rate applicable to the taxpayers may change in the future. It is possible that the taxpayer may be in the maximum tax bracket when they pay into the pension fund. However, when they receive benefits, they may not be employed elsewhere and hence may not be required to pay tax or may fall in a lower tax bracket.

To sum it up, governments all over the world have to make important decisions that affect their present revenue as well as encourage people to invest in pension funds over the long term.

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Pension Funds