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Write to Kate with your pension problem: pensionsdoctor@Finance.co.uk. Columns are published twice a month on Tuesday mornings
Dear Kate,
I am 55 and therefore eligible to cash in a £195,000 pension, which is from a previous employer. I am also paying into my current pension from working in local government for the last five years. I currently earn £44,200pa, approximately £38,000 of which is taxable.
Should I use my pension to pay off my £100,000 mortgage, or would the tax bill be prohibitive?
AC, Hampshire
Using your pension to pay off your mortgage may sound tempting but this isn’t a decision that should be taken lightly.
It’s important that you understand the financial implications of accessing your pension before you do anything. As the pension pot you are considering cashing in is sizeable, you would benefit from getting tailored financial advice.
You’re right that once you reach your 55th birthday you can access your defined contribution (DC) pension pot and take as much as you like. But taking any money from your pension early to help pay off loans or other debts will have long term consequences, especially on your standard of living when you come to retire.
There are several considerations you should weigh up before deciding to use your DC pension pot to pay off your mortgage.
1. Income in retirement
The purpose of a pension is to provide you with an income in retirement. If you cash in your pension to pay off your mortgage, you need to work out if you will have enough income to live on when you stop working.
You said that you have one other pension with the local government, which will be a defined benefit (or final salary) scheme. You haven’t mentioned how much this is worth, but as you’ve only been paying into it for five years, it’s unlikely to be a significant amount yet.
However, you still have the potential to build up further pension entitlement until you retire, including by making additional contributions.
You are likely to be entitled to the new State Pension from your 67th birthday, the full rate is currently £9,110 a year. You must have built up 35 qualifying years of National Insurance contributions (NICs) or credits to receive the full amount.
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2. Low interest mortgage
If your mortgage has a low interest rate, it’s a good idea to compare what you’re paying with the investment return you’re making on your pension funds.
You may find that you won’t save much interest by paying off your mortgage balance in one go or in stages. You should also check whether there are any penalties or charges for paying off your mortgage early.
3. Fluctuating pension values
You may find that the value of your DC pension pot has been fluctuating recently due to the coronavirus crisis.
Cashing in your pension now could mean that you won’t have the chance to see your funds benefit fully from any further market bounce back.
4. Income tax implications
Cashing in your DC pension pot of £195,000 in one go will mean facing a large tax bill, so you could receive much less in your bank account than anticipated.
Up to a quarter of your DC pension pot, £48,750, can be taken as a tax-free lump sum. The remaining balance, £146,250, is treated as taxable income in the tax year in which you take it.
If you cash in your DC pension this tax year you would pay a massive income tax and NICs bill of £71,332 from your combined pension and earnings.
That is based on you being a basic rate (20pc) taxpayer. Cashing in all your DC pension in one go would move you into the highest tax band of 45pc as your total taxable income will increase to £184,250 (£146,250 pension income and £38,000 taxable earnings). And you would lose all your personal allowance.
Your total income this tax year would be £239,200, but after tax and NIC your net income would be significantly lower at around £167,868. This would be enough to pay off your mortgage balance of £100,000 and leave you some money left over.
The downside is that you would have paid a significant amount in income tax and lost the potential of future retirement income.
It’s worth pointing out that your DC pension provider would probably use an emergency tax code to tax your pension at the time of payment. This usually results in too much tax being deducted initially, so your income would be even lower, and you would need to reclaim any overpaid tax from HM Revenue & Customs.
Instead of cashing in all your DC pension pot in one go, you may be able to take it as a series of lump sum payments spread over several tax years, so you don’t overpay income tax and you can get more benefit from your pension savings.
Alternatively, you could move your DC pension pot into a flexi-access income drawdown policy with a pension provider. Under this option you can withdraw your 25pc tax-free lump sum and leave the remaining invested, taking out taxable income payments as and when you wish to.
5. Limit on future contributions
Another point to bear in mind is that cashing in your DC pension will reduce the amount you and your employer can pay into a DC pension in the future, from £40,000 to £4,000 a year without incurring a tax charge.
One final option to investigate if you have other savings or investments, is to check whether you could use these to help pay off your mortgage instead of using your pension. Again, you’d want to compare the returns you’re making on them against the low mortgage interest you’re paying.
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