SPECIAL FEATURE: Draw down pensions with caution
Usually it will be a good idea for clients to pay off their mortgage early. Debt, even at low interest rates, still needs servicing and must ultimately be paid back, so it is understandable that many borrowers are keen to pay off their mortgages and other loans before they reach retirement age.
Since 6 April “Pensions Freedom” allows those over age 55 to access some or all of their pension funds early and many middle aged mortgagees are using this to pay down their debts. While for some this will make perfect sense and save them future interest payments, for many it could be a very expensive mistake.
This is particularly the case where more than just the 25% tax free portion of the pension fund needs to be accessed to extinguish the debt. If a larger sum is needed, the balance of the fund withdrawn will be subject to income tax at the pension owner’s highest marginal rate. This leads to a very large tax bill and a reduction in the funds available immediately and less in the longer term retirement fund and future income from it.
A recent case illustrates this point.
Dave is 61 his partner Jane 57; they are both working and have an interest-only mortgage of £100,000 with £45,000 in an offset account. They can easily afford the interest payments at a rate of 3.9% but their lender has contacted them to ask how they propose to pay off the balance of their mortgage before Jane is 65?
Dave plans to work till he is 65 and Jane will probably retire then too. Dave already has a defined benefit pension of £20,000 per annum in payment. He also earns £37,000 pa. He and his employer are paying 10% each into a personal pension scheme valued at £100,000. He also has a personal pension from his last employer which has a fund value of £67,000. Dave thought it might be a good idea to cash this in and pay off the balance of the mortgage ahead of retirement.
He is aware that the fund, apart from the first 25%, will be taxable but he still wants to use the fund to pay off the mortgage early. The net payment from the pension would be £16,750 tax free and £50,250 taxable. The problem is that this would all be taxed at 40% but when added to the £57,000 he is already receiving and would lead to the loss of some of his personal allowance. Every £2 over £100,000 results in the loss of £1 of allowance. This would reduce Dave’s personal allowance from £10,600 for 2015/16 to £6, 975. The total tax bill would therefore be £21,550, leaving a net payment of £45,450. The interest saved over 4 years is £7,020.
Paying £21,550 of extra tax to save £7,020 of interest does not make sense.
If Dave simply waits till he is 65, his employer sponsored pension would have grown to £130,000 this together with his other pension could pay out £49,250 tax free with which to pay off the mortgage and leave a fund of £147,750 to fund additional retirement income.