Should I top up my pension or pay off the mortgage?
Q: I can't decide if I should make additional voluntary contributions (AVCs) to my pension or overpay on my mortgage. Can you help?
I am 55 and divorced and I plan to retire when I'm 65. My mortgage is not large - £26,000, with nine years left to run. It's currently on a fixed rate of 5.9% until 2014.
Philip Pearson is a partner at P&P invest in Southampton.
A: An AVC is a top-up to an occupational pension and is slightly different from simply making extra contributions to your existing pension. Most are set up as separate funds with insurance companies (although some are run 'in-house' as part of your employer's pension scheme and tend to be cheaper).
My advice would be to make additional pension contributions first, as I would expect this option to have lower charges than payments into an AVC.
The merits of funding a pension over the repayment of debt need to be considered against your current financial situation, objectives for the future and attitude to risk.
With a mortgage interest rate of 5.9%, your pension would need to grow by up to 8% a year to match the cost of borrowing, after taking into consideration pension scheme charges. A speculative attitude to risk would need to be adopted in order to have any hope of achieving this level of return over a period of nine years.
If you think of yourself as a cautious investor, then my advice would be to go for the risk-free option of repaying your mortgage over investing extra in your pension. You should consider the option of remortgaging to obtain a more favourable interest rate. If this can be achieved, then boosting your pension may be more viable.
Your tax bracket also affects your options. Many people close to retirement (who may be working part-time) or who have already retired are basic-rate taxpayers.
It doesn't make much sense to make additional contributions into a pension unless you are a higher-rate taxpayer. This is because any money put into a pension receives tax relief based on your income tax bracket, so a higher-rate (40%) taxpayer would only have to pay in £60 to get £100.
After retiring, most people drop to the basic-rate tax bracket, so will pay only 20% tax on their pension income.
In contrast, there are no significant tax advantages for basic-rate taxpayers, who get 20% tax relief on contributions, but will pay tax at the same rate on their pension income after retirement.
In my opinion, a far better alternative if you are a basic-rate taxpayer would be an individual savings account. Unlike pensions that offer tax relief on the way in but are taxable on the way out, with a cash ISA you invest taxed income but don't have to pay any income tax when you withdraw money.
The advantage of this type of savings account over pensions is the flexibility of being able to access your money whenever you like. However, it is worth noting that as you are aged 55 you can already access your pension.
THE ADVANTAGES OF OVERPAYING ON YOUR MORTGAGE
David Hollingworth is a mortgages expert at London & Country Mortgages in Bath.
Overpaying on a regular basis is a great way to pay off your mortgage faster, and save interest as a result. Doing this will generally amount to a better return than putting the cash into savings.
For example, overpaying £100 a month on your current mortgage terms (5.9% until 2014) would shave two years and seven months off the mortgage and save you £2,351.
When considering overpaying, it's always important to check the level of flexibility that your mortgage deal has - many mortgage deals carry early repayment charges. But even these will often have some flexibility to make overpayments, typically up to 10% of the outstanding mortgage balance a year.
Changing mortgages without moving home. Property owners chiefly remortgage to get a better deal but some do so to release equity in their homes or to finance home improvements, the costs of which are added to the new mortgage. Even though you’re not moving house, you still need to engage solicitors, conveyancing and the new lender will require the property to be surveyed and valued.
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.
Additional voluntary contributions
If you’re a member of an occupational pension scheme but want to increase your contributions to help boost your income in retirement, this is where AVCs come in. An AVC is a top-up pension that sits alongside your company pension and is administered by your employer. You get tax relief on your contributions and, if you move jobs, you can apply to transfer your AVC plan to your new employer or your AVC your contributions have to stop with your old employer and you will need to start a new AVC plan with your new employer. An AVC linked to a company scheme is subject to the rules of the main pension. (See Free-standing additional voluntary contribution).