Ways for providing tax efficient savings (Part 1)

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Some possible venues for putting your money for the long-term while reducing income tax, may be: contributions to approved provident fund, pension fund or term/life insurances; or any combination of them. In this article, we shall look into approved provident funds, their structure, purpose, regulations and tax benefits.

A provident fund is retirement benefit schemes where employer and employee pay money. The fund is setup as a separate legal entity and must be approved by the Department of Social Insurance, which regulates all provident funds in Cyprus and ensures their efficient operation in favour of the employees. The employees making contributions elect the Management Committee of the fund, which is responsible for the management, administration and investment of the moneys.Tax efficient saving with provident fund

The purpose of the provident fund (which in its nature could be defined-contribution or defined-benefit plan) is to help employees save regularly a portion of their salary, so that when the employee retires or leaves the company, he or she receives a sum of money. The added benefits to the employee are: the employer also makes a contribution, the fund is invested into a diversified investment portfolio and payment to an employee out of the provident fund is tax-free.

Since different provident funds have different rules and regulations; it is of utmost importance for you to read and understand them. For instance, you need to know what will be the contribution by the employer (e.g. matching your contribution and up to what limit or paying fixed percentage of your gross salary), the terms of when you can receive payment and the way the amount of the payment will be determined, where funds will be invested etc. Upon termination of employment for example, provident funds will pay your contribution in-full, but may apply prorata to the employer’s contributions, depending on the years of employment at the company.

Contributions by the employer to the provident fund are a type of benefit, not subject to income tax or social insurance and at the same time deductible expense for the employer. Furthermore, your contributions (i.e. allowable deduction) reduce taxable income, allowing you to pay less income tax.

For employees who earn less then €20,923 per year, provident fund contributions or payments to life insurance will not adding any tax benefit, because the net taxable income (€20,923 less 6.8% social insurance) will be €19,500, which is anyway taxed at 0%.

However, for every additional EUR of income, one will save on tax if contributing equivalent amount to provident fund or life insurance. Say, Alice has taxable income of €45,000 per year, contributes €4,440 (9.87% of her income) to a provident fund and is deducted 6.8% social insurance (€3,060). The net taxable income will be €37,500 and income tax thereof €4,135. In this example, because of taking full advantage of the allowable deductions, Alice saves 24% (€1,332) of income tax and at the same time has put €4,440 of savings.

Unfortunately, as everything else in life, there is also a limit to allowable deductions. The total of: social insurance, provident fund, medical fund, pension fund and life insurance premiums cannot exceed 1/6 (16.7%) of taxable income. So, if Alice paid €5,440 to the provident fund instead of €4,440, the additional €1,000 will be disallowed and not result in additional tax saving.

If the employer and employees are willing to make contributions they could easily incorporate their own provident fund. Some provident funds in Cyprus consist of just handful of employees, other of several thousands.

On the other hand, if your employer is unwilling to make contributions but you still want to minimize your income tax, life insurance may be an option to consider.

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