How to use your pension to pay off your mortgage quicker

As a high earner, you might decide to use your disposable income to simply overpay your mortgage each month.

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%.

Taxes and your mortgage

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):

  • £29,358.62 is taxed at an additional National Insurance rate (2%) — costs £587.17
  • £29,358.62 is taxed at the higher income rate (40%) — costs £11,743.45
  • A further £12,570 is also higher income rate (the result of tax trap and loss of personal allowance) — costs £5,028

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.

Paying off your mortgage faster

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:

  • pay off your £250,000 mortgage in just over eight and a half years – 13 years faster than overpayments;
  • shave a further one and a half years off this timeline when investment growth is added;
  • save over £360,000 in tax.

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.

Disclaimer: Information is correct to the best of our understanding as at the date of publication. Nothing within this content is intended as, or can be relied upon, as financial advice. Capital is at risk. You may get back less than you invested.

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