Whether you’re an individual or a couple, a universal financial goal is often to pay off your mortgage as quickly and cost-efficiently as possible. However, with such complexities, this can prove highly difficult.
Tax plays a massive factor in the type of challenges you’ll face, particularly for high earners. Nevertheless, there is a way you can pay your mortgage off significantly quicker – using your pension.
By pairing this method with the help of financial planning advice, you’ll be making smarter, more accurate investments in no time.
To find out why this method is so important, and exactly how it works, keep reading on!
The dreaded tax trap
The fundamental struggle for high earners with an income upwards of £100,000, is the substantial tax on their earnings. For these high earners, a large portion of income is taxed at essentially 60%. This is widely known as the 60% tax trap.
For higher rate tax payers (with taxable income of £50,271 – £150,000), you’ll pay 40% Income Tax on all your earnings. On top of this, once you reach £100,000, your personal allowance (the £12,570 of tax-free income as of 2021/22) is reduced by £1 for every £2 of income. This means for an income of £125,140, your tax-free personal allowance is now £0.
Put plainly, if you’re given, for example, an additional £1,000 bonus from work:
- This will then be taxed at 40%, costing you £400
- You’ll lose an additional £500 of your personal allowance, resulting in £500 more of your income being taxed at 40%, thus losing you a further £200.
In the end, your £1,000 bonus has now been hit with the 60% tax trap, losing you £600, and leaving you with only £400.
So, you most likely are wondering how this detrimental trap can be avoided, and how you can begin to pay off your mortgage without these excessive reductions through tax.
Paying off your mortgage with your pension
Whilst the 60% tax trap can be a frightening reality, it can actually be avoided using your pension contributions. Your pension contributions allow you to claim tax relief, which lowers the amount of taxable income, and helps you regain some of your tax-free personal allowance.
Let’s say, for instance, you earn the exact amount that removes your entire personal allowance – £125,140. If you were to make a pension contribution of £20,112, you would receive tax-relief from the government, adding an extra £5,028 on top at the basic rate. Your £20,112 has now become £25,140 without any extra cost, and furthermore, you could claim an extra £5,028 in higher-rate tax relief on your tax return.
Not only this, but your contribution has lowered your taxable income by £25,140, so your earnings are now down to £100,000. This means your personal allowance of £12,570 is restored, and a further £5,028 is saved in tax (40%).
Overall, you have made a benefit of £15,084, by simply making pension contributions.
Applying this to your mortgage
Now, when it comes to your mortgage, this clever strategy of tax-free investing can provide you with a larger sum of money, in a shorter amount of time.
For example, if you wanted to pay off a mortgage of £250,000, through monthly (£1,000) or annual (£12,000) payments, and you had an income of £129,358.62, you would lose a large amount in tax:
- £587.17 from National Insurance (NI)
- £11,743.45 from 40% income tax
- £5,028 from your personal allowance loss and additional income tax
Overall, you would have paid £17,358.62 in tax, leaving you with exactly £12,000 for your mortgage. At this rate, it will take 21 years to pay off your mortgage, and require a total income of up to £30,000.
However, if you use your pension contributions, with the inclusion of tax-relief, you’ll have the funds to pay off your mortgage in no time.
Take that same annual £29,358.62, and add it to your pension. As explained above, this contribution is gross of all tax, and you are now free from the 60% tax trap. Moreover, when you want to access your pension, you can take 25% of it completely tax-free.
Depending on the total amount you have in your pension, this means a maximum of £268,275 of tax-free savings – more than enough to pay off your £250,000 mortgage.
With this method, you can pay off your £250,000 mortgage in just over eight-and-a-half years, and save over £360,000 in tax, 13 years quicker than the alternative process. Also, if you include investment growth, this could take another one-and-a-half years off this timeline.
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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