Your IndustryMay 7 2015

Taking cash and paying off debt

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When looking to pay off a debt with pension income, Claire Trott, head of technical support at Talbot & Muir, says the biggest consideration should be “how did they get the debt in the first place?”

Reducing future income to pay back this debt may mean that they will be more likely to get into debt again in the future, Ms Trott points out.

She says: “Retirement is a long-term issue and debt repayment may just be a short-term pain that needs to be dealt with in normal expenditure rather than eroding pension assets.

“If the income tax on a payment outweighs the interest then you should really be thinking about if the debt can be reduced in another way or over a longer period to reduce the tax burden, because you will not only be losing income in the future you will not have saved anything by paying off the debt early.”

Rod McKie, head of retirement propositions at Zurich Life, says calculations of if a pension should be used to pay off debt should take in factors such as their current health, their tax position and their plans for the equity in their home.

Mr McKie says balancing current and future needs is essential to ensure the right outcome for the specific circumstances.

James McLeod, head of pensions at AES International, says it can frequently be better to pay off debt in almost every circumstance. He says this is particularly the case when you are entering a period of your life when you will no longer be earning money.

However, Mr McLeod agrees that there are some circumstances when debt can be serviced economically through other investments, but this requires specialist knowledge and financial advice.

A simple rule of thumb could be that if the amount used to pay off debt reduces total outgoings by more than that amount would have generated in income over the whole retirement plan, it is worth considering. This would limit the option to only the most expensive debt.

Jamie Jenkins, head of pensions strategy at Standard Life, says when weighing up whether to pull cash out of a pension to pay off debt it all comes down to the investment performance of the pension, the tax due on the cash taken and the interest rate being charged on the debt.

If the debt is high interest, then Mr Jenkins says taking cash and clearing that debt may make sense. However if taking that cash puts the client into a higher tax bracket and liable for 40 per cent income tax, then Mr Jenkins says it may not be a good idea.

For some, he says it may be sensible to pay the debt off over a couple of years, if there are no other assets available.

Mr Jenkins says: “This could mean the client avoiding higher rate tax but, of course, this has to be considered in relation to the interest rate incurred on the ongoing debt.”

Alistair McQueen, head of policy and compliance business protection at Aviva, says using pension money to pay off debt should be a last resort.

If the client has a heavy monthly debt bill, Mr McQueen says it could be tempting to see the pension pot as a means of paying off this bill to relieve this burden. Such temptations should be approached with caution, he cautions.

Mr McQueen says: “Pension savings are designed to fund your life through retirement – which could be 30 years or more.

“Using the pension pot to ease a short-term debt pain, could leave the client with a financially strained life through the rest of your retirement.

“Taking all cash at once could also bring with it a significant tax bill that would significantly reduce the value of the client’s pension pot.

“This action could also push them into a higher income tax bracket which could increase financial difficulties.

“If the client is in receipt of means-tested state benefits, these could also be negatively impacted by taking a lump sum from the pension.”

Admittedly, Mr McQueen says if the individual finds themselves ‘stuck’ with a debt carrying a very high interest rate, then there could be sense in using some pension money to relieve this burden, but only once other options have been exhausted.

So, prior to using the long-term pension saving to pay off debts, Mr McQueen says it would often be sensible to consider other methods such as economising, cutting back on expenditure, or generating additional income, maybe via a second job or taking in a lodger.

He says: “Without due consideration in these circumstances, it could be very possible for the client to act in haste but repent at leisure.”