In our weekly series, readers can email in with any question about retirement and pension saving to be answered by our expert, Tom Selby, head of retirement policy at investment platform AJ Bell. There is nothing he doesn’t know about pensions. If you have a question for him, email us at [email protected].
Today’s question is: I have received £3,000 from my grandad when he died and I’m trying to decide whether to pay off some of my mortgage early or boost my retirement savings by contributing to a Self-Invested Personal Pension. I know you can’t give me direct advice on what to do, but what sort of things should I be thinking about?
Tom’s answer: I am often asked questions like this, particular at the moment with mortgage rates rapidly rising as the Bank of England attempts to contain spiralling inflation. The answer will depend on a range of factors.
The first thing you should consider when choosing where to put any money is whether you have any higher cost debts that need paying off. For example, it would make little sense to use a £3,000 windfall to pay off a mortgage charging, say, 4 per cent interest if you have credit card debt accumulating interest at 40 per cent.
If you don’t have any high-cost debts, your next port of call should usually be building your “rainy-day” fund – a pot of money held in a cash account for emergencies.
It’s up to you how big you want this reserve to be, but generally holding three to six months’ fixed expenses in cash is a sensible target. Use websites like MoneySavingExpert to find the best paying easy-access cash account on the market.
Once you’ve paid off any high-cost debts and set up a rainy-day fund, you can start to think towards the long-term – which brings us to your question. Firstly, check your bank or building society allows you to pay off part of your mortgage early without imposing a penalty. The existence of a penalty doesn’t necessarily mean paying off your mortgage won’t benefit you financially, but it will clearly reduce any benefit.
Usually, when choosing between paying off debt or invest, the key is whether the returns you expect to get from your investments will be higher than your mortgage interest repayments.
So, if your mortgage has an interest rate of 4 per cent, then your investments would need to deliver returns of at least this amount post-charges for the decision to pay off. Historically, this hasn’t been a high bar for a diversified portfolio or fund to achieve over the long term, although there are no guarantees when it comes to investing. Of course, with interest rates – and therefore mortgage borrowing costs – increasing, your investments might need to work that bit harder to make a decision not to pay off your mortgage worthwhile.
The extra boost for pension contributions is key
However, there is another key factor to consider when it comes to saving in a pension like a Self-Invested Personal Pension (SIPP) – tax relief. Pensions benefit from upfront tax relief at 20 per cent (equal to the basic rate of income tax), meaning if you contributed £3,000 it would automatically be boosted to £3,750 in a pension.
What’s more, if you are a higher-rate taxpayer, you’ll be able to claim an extra 20 per cent tax relief from the taxman, while an additional-rate taxpayer could claim an extra 25 per cent. Once invested in a pension, your fund can grow completely free of tax.
There are a few tax limits you need to be aware of when contributing to a pension. The amount you can personally contribute to a pension each year is limited to 100 per cent of your earnings, with a cap on total annual contributions – including any contributions you receive from your employer and tax relief – set at £60,000. If you have no taxable earnings, you can still contribute up to £3,600 a year, inclusive of tax relief, into a pension.
If you have “flexibly accessed” taxable income from your pension from age 55, this annual allowance drops to £10,000. Flexibly accessing your pension includes things like taking taxable income via ‘drawdown’ (where you keep your pension pot invested while taking an income) and withdrawing an ad-hoc lump sum directly from your fund (where 75 per cent of this lump sum is subject to income tax and 25 per cent is tax-free).
Similarly, those with very high earnings may have their annual allowance “tapered” from £60,000 to as low as £10,000.
Pension versus mortgage?
Provided you are happy to wait until age 55 to touch your money (rising to age 57 from 2028) and have sufficient annual allowance to make a £3,000 contribution, the upfront boost provided by tax relief means money invested in a pension is likely to deliver a bigger bang for your buck from a purely financial perspective than paying off your mortgage early. Once you access your pension, a quarter will be available tax-free, with the rest taxed in the same way as income.
If you want to invest your money tax free but with easier access, a Lifetime ISA (Lisa) might be worth considering as an alternative to a pension. If you’re aged 18 to 39, you can subscribe up to £4,000 a year into a Lisa and receive a 25 per cent upfront bonus (ie, a maximum bonus of £1,000 per year), with investment growth tax-free, just like a pension. You can then access the money tax-free to put towards a deposit on your first home (provided it is worth £450,000 or less), from age 60 or if you become terminally ill.
However, if you access the money before age 60 for any other reason, you will be hit with a 25 per cent early withdrawal charge, meaning you might get back less than you initially put in.
One final thing to consider is that the above analysis is based purely on financial considerations. For some people, paying off a mortgage may have an emotional significance, which shouldn’t be dismissed.
As always, if you aren’t sure, it’s worth speaking to a regulated financial adviser to discuss your options.
