Third pillar: is it worth it?
Opening a third pillar can seem like a no-brainer. But it’s not always worth it.
The most common personal finance advice in Switzerland is probably: open a third pillar account to lower your taxes. You’ve probably heard it before. But just in case you haven’t, here is a quick recap of what a third pillar is:
A third pillar is basically money on a locked account destined to be withdrawn at retirement age. To encourage you to wire money to that account, the swiss government makes transfer to this account deductible from your taxable income up to almost 6,900 francs per year. Which means: the government renounces to the taxes you should pay on that amount. For instance, if you have a marginal tax rate of 33.3% (that’s how much taxes you’re paying on the last franc you’ve earned) and decide to put 6,000 francs on a third pillar account, your taxes will be 2,000 francs lower that year. Pretty cool, huh? I should add that by “third pillar”, I mean pillar 3A, and not 3B. Pillar 3B is not tax-deductible in most cantons and is therefore a simple life insurance contract.
Third pillars can be opened at a bank or at an insurance. Third pillars at insurance companies are scams, to be blunt. In Michael Scott’s words: Don’t ever, for any reason, do anything, to anyone, for any reason, ever, no matter what, no matter where, or who, or who you are with, or where you are going, or where you’ve been, ever, for any reason whatsoever, that would lead to opening a third pillar at an insurance company. But this will be the topic of a separate article.
Pros and cons of a third pillar
Today we will focus on third pillars at banks. And in particular, at banks which allow you to invest that money in low-cost index funds.
There are several features that make third pillars attractive. We’ve already talked about the first one: contributions are deductible from the taxable income.
The second one is less popular, because it’s less significative: whatever is on the third pillar account doesn’t count in your taxable wealth.
The third one is also less talked about, but it is great: dividends are not taxed on the third pillar. Which makes for significant tax savings over the long run.
There is nonetheless one drawback: when the third pillar is withdrawn, usually around retirement age, then taxes are due. So, in reality, taxes on the third pillar are only postponed, not completely canceled. What’s the point then? Now or later, what’s the difference? Well, the difference is in the amount of taxes due. While the tax savings are based on your current marginal tax rate, the whole amount withdrawn will be taxed separately using a different progressive tax scale. That means that all the compound interest gathered throughout the years will also be taxed at the exit. This is significant because investment gains outside of a third pillar are not taxed at all. Which raises the question:
Which is better? To get the immediate deduction and have investment gains taxed at the exit OR to renounce to the third pillar entirely in order to preserve the tax exemption of capital gains?
John and Sally – a comparison
John is 25 and invests 6,000 francs on a third pillar account every year for 40 years. Since his marginal tax rate is 33.3%, he gets to pay 2,000 francs less taxes every year. He choses a bold strategy: all his third pillar money will be invested in stocks. On average his money earns 7% per year (5% price appreciation and 2% dividend). But because the third pillar fund doesn’t work for free, this performance is reduced by 0.5% of yearly fees.
At age 65, John has around 1.053 million on his account. Not too shabby. But now comes the tax man and he demands 172k (!!), which leaves John with 882k. Link to the simulator (assumptions: single, no religion, lives in Zürich).
Sally (same age and same marginal tax rate as John), on the other hand, doesn’t believe in the swiss retirement system and wants to do everything on her own. She invests 6,000 in index funds directly. She doesn’t get lower taxes. She actually has to pay higher taxes every year because dividends are additional income in the eyes of the tax office, so the performance of the investment is reduced.
After 40 years, she gets a whooping 1.01 million francs, tax free, since capital gains aren’t taxed. I haven’t included the impact of the wealth tax though.
So, it would appear that Sally comes on top… Except that we didn’t consider the 2,000 francs in tax savings. If that money had stayed in cash, it would amount to 80k. That’s still not enough to make up for the difference. But if that money had been invested in a broker’s account, all in stocks, it would amount to 336k, which would bring John’s total to 1.22 million. An amount significantly higher than Sally’s.
So, to answer the question of the title: yes, it is worth it to invest money via a third pillar if, and only if, the tax benefits are invested as well. Otherwise, a third pillar is not worth it.
Funny how you never hear about that from financial advisers huh?