How to use your pension to pay off your mortgage quicker

It may seem like a sensible idea, and the right decision in certain circumstances, but what if we told you there may be a better use of your money?

In fact, with some financial planning, and contributing to your pension, you could even manage to pay off your mortgage, twice as fast, compared to overpaying.

Read on to find out more.

The 60% tax trap when earning over £100,000

Firstly, it’s worth understanding a wrinkle in the UK tax system, which catches out a lot of high earners. According to Saltus, a financial planning and investment management company, this is known as the 60% tax trap.

When your income reaches £100,000, your tax-free personal allowance (the amount of income you do not have to pay tax on) is gradually cut by £1 for every £2 of additional income.

Therefore, when your taxable earnings reach £125,140, you lose your personal allowance entirely.

If you were to earn £1,000 over the £100,000 threshold, then this will be taxed at 40% — the higher income tax rate — leaving you with £600. You’ll also lose £500 of your personal allowance, with that amount also being taxed at 40% and costing you another £200 in tax. As a result, your additional £1,000 has ended up costing you £600, and you’ve paid an effective tax rate of 60%.

Imagine you have a mortgage of £250,000, and you earn exactly £129,358.62. If you wish to overpay £1,000 of your mortgage each month (£12,000 a year), you’d need to consider the income required to make such payments.

If we take your income over the £100,000 threshold, this is how much tax it would cost you (as of tax year 2021/2022):

In total, you would have paid £17,358.62 in tax, with £12,000 remaining.

In simple terms, it would require almost £30,000 in income to make the £12,000 annual mortgage payment. To pay off your £250,000 mortgage, it will take almost 21 years and cost over £600,000 of income.

It’s also worth noting that from 6th April 2022 to 5th April 2023, National Insurance contributions will increase by 1.25%. The increase will not apply if you’re over the State Pension age.

There is another way you can pay off your mortgage, which could save you a significant amount in tax, and even speed up the process.

Using the same figures as above, and you instead contributed £29,358.62 to your pension, this would be gross of all tax. In addition, you’d avoid the dreaded 60% tax trap we’ve previously explained.

When you reach retirement age, you can withdraw 25% of your pension, completely tax-free. Depending on the size of the pension pot, you can take a maximum of £268,275 free of tax – more than enough to pay the £250,000 mortgage in full.

By effectively using your pension, you can:

If you’re looking to overpay your mortgage, it may be time to consult with a pension adviser, to understand the most tax-efficient way to reach your financial goal.

If you need expert advice or help and support with your pension and retirement planning from a trustworthy source, contact Unbiased today.

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