Your mortgage coming to an end may not be the only option open to you when funding your pension.
Many people have savings plans which are due to mature, or money in bank accounts earning a paltry rate of interest.
Maturing endowment policies
A popular method of saving in the 1980s and 1990s was endowment policies. In many cases, these were linked to interest-only mortgages. However, many savers switched to repayment mortgages in the early noughties because investment returns earned by endowment policies were no longer enough to repay the mortgage.
Nevertheless, a lot of people hung onto their endowment policy as a savings plan, no longer linked to their mortgage.
Given their popularity, many of the policies taken out in the late 1990s, over a typical term of 25 years, are now reaching the point at which they mature.
If the proceeds of an endowment policy were reinvested in a pension, this could create a substantial pension fund at retirement.
Money held in bank deposits and cash ISAs
Another potential source of funds is excess money held in bank deposits.
It makes good financial sense to hold at least some money in cash. Enough to cover 3-6 months income if you are working, or 2-3 years income if you have already retired and are taking income withdrawals from an invested pension fund (in this case, the cash may be held in a bank account or cash fund inside your pension).
You might also want to hold some cash to pay for emergency repairs to your home or car, or to replace white goods that break down and can’t be repaired.
After making sure you have enough cash, you could consider investing any excess in your pension where it will attract tax relief.
Jane is 58-years-old. An endowment policy she took out 25 years ago has just matured with a value of £25,000. Jane doesn’t have an immediate use for the money and was considering transferring some to a cash ISA and the rest to a bank deposit.
Jane is still working and is a higher rate taxpayer earning £70,000 a year. Jane pays £3,000 a year into her workplace pension and her employer matches this.
The annual allowance for pension contributions is £40,000. This is the maximum amount that qualifies for tax relief if paid into a pension in any one tax-year. Unused allowances from the previous three tax years can be carried forward (up to £40,000 each year), making four years’ worth of allowance in total. This means someone who has a pension but hasn’t paid into it recently could potentially pay £160,000 in one tax year (assuming that they had the earnings to support such a contribution).
However, higher rate taxpayers like Jane only qualify for higher rate tax-relief to the extent that they pay higher rate tax. As Jane earns £70,000, and higher rate tax is paid on all income above £46,350 (England, Wales and Northern Ireland), she can put up to £23,650 into her pension in the current tax-year and receive higher rate tax relief.
As Jane already puts in £3,000, she can put in another £20,650 in the current tax-year and still get higher rate tax relief on her contribution.
Jane decides to put £16,000 into her pension from the proceeds of her maturing endowment, and another £9,000 in the next tax-year which starts on 6th April 2019.
The £16,000 she pays in now attracts immediate tax relief of 20%, meaning that Jane’s contribution into her pension is £20,000 (20% of the gross amount of £20,000 = £4,000 tax relief).
As Jane is over 55, she can take money back out of her pension immediately. However, Jane decides to wait until next year when she gets the remainder of her tax relief – another £4,000 when she submits her self-assessment return in July 2019.
In July 2019, Jane takes a quarter of her pension as a tax-free lump sum – an amount of £5,000.
Jane now has a total of £18,000 in cash, made up of the remaining £9,000 from her maturing endowment policy, £4,000 higher rate tax relief from her £16,000 net pension contribution and £5,000 tax-free lump sum.
Jane also has £15,000 still in her pension after taking the tax-free lump sum.
Jane’s income in the 2019/20 tax year has also gone up to £76,000 meaning that she can pay the whole £18,000 she has in cash into her pension and get higher rate tax relief. This payment receives immediate tax relief of 20% or £4,500, making the total new gross contribution £22,500.
In addition, Jane will receive another £4,500 in higher rate tax relief when she submits her self-assessment return in July 2020. If she also paid this into her pension with 20% tax-relief, the contribution would amount to £5,625 making her pension pot a total of £43,125.
Jane now has £43,125 in her pension, £15,000 of which no longer has a tax-free lump sum available, and another £28,125 from which she can take a further tax-free lump sum of £7,031 whenever she wants.
As you can see, even assuming zero investment growth, Jane has turned a £25,000 maturing endowment policy into a pension pot of £43,125 in less than two years just using tax reliefs.
Around £36,000 of Jane’s pension pot is taxable but she intends to wait until she retires to draw the taxable part, when she anticipates she will be a basic rate taxpayer. Until then, she has access to the £7,031 tax-free lump sum if she needs it (in July 2021, she will also get another £1,125 in higher rate relief - 20% of the £5,625 paid in July 2020 - when she does her self-assessment return).
There are no rules that prohibit the recycling of higher rate tax-relief as a new pension contribution, but there are rules which limit the recycling of tax-free lump sums in this way. However, as long as the tax-free lump sum taken in any 12-month period doesn’t exceed £7,500, these rules don’t apply. It’s worth considering financial advice if you’re unsure how these rules could affect you.
Jane has only taken and recycled a tax-free lump sum of £4,687.50 into her pension in July 2019 and has not taken any other tax-free lump sum in the previous or following 12-month period. She has therefore not contravened the rules which prohibit the recycling of large tax-free lump sums.