The pros and cons of using your pension pot to pay off debt

Category: News & United Kingdom

When you decide to retire, you may have big plans for what to do with your tax-free lump sum. Perhaps you want to buy a new car or head on the trip of a lifetime – but could repaying debt leave you in a more stable financial position?  

Considering current UK interest rates, this could be an attractive proposition. After over a decade of a sub-1% base rate, MoneyWeek now reports that average interest rates on five-year fixed-term mortgages are sitting at 5.23%. 

For many, this means the cost of servicing debt has increased substantially in the last couple of years. The Guardian reports that, in 2024, UK homeowners will likely see a combined £19 billion rise in mortgage costs.

Faced with this prospect, it could be beneficial to pay off outstanding debt using cash from your pension pot. However, there are some implications to doing so that it is important to be aware of.

Read on to learn more about the pros and cons of taking money from your pension to pay off debt.

Pension Freedoms have changed the way you can access your pension

Following the Pensions Act 2014, you now have more ways to access your pension than before. Known as “Pension Freedoms”, this makes it easier to use your pension to pay off debt.

Normally, you cannot withdraw money from your pension until the age of 55 – this will increase to 57 in 2028 – and depending on how you access your pension, you may have to pay tax on any withdrawal over and above your 25% tax-free lump sum.

The ability to do this could make it very enticing to withdraw enough to pay off your debts in one payment. However, there are implications to doing so – more on this later.

You can also make regular withdrawals from your remaining pension pot whenever you like. These withdrawals will usually be subject to Income Tax at your marginal rate.

Taking money out of your pension could leave you in a worse financial position

There are several potential negative implications to taking money out of your pension early. 

Firstly, withdrawing money from your pension has potential tax implications. If you withdraw a lump sum from your pension pot that is larger than 25% of the value of your pension, you may have to pay Income Tax on the amount you withdraw over the 25%.

If it is a significant amount, this could push you into a higher tax bracket, meaning you could lose 40% or 45% of your lump sum to Income Tax.

Alongside Pension Freedoms, the Pensions Act 2014 also introduced the Money Purchase Annual Allowance (MPAA). The MPAA limits the amount you can contribute to your pension from your earnings once you have flexibly accessed it. 

In the 2023/24 tax year, the MPAA is set at £10,000. This means, if you do take money from your pension to pay off debt, and you continue to work and make pension contributions, you will only be able to contribute a maximum of £10,000 a year to your pension without an additional tax charge.

This is substantially lower than the £60,000 Annual Allowance which applies otherwise, so it is worth carefully considering your options if you are thinking of accessing your pension to repay debt.

Taking money from your pension to pay off debt could also reduce the amount you have to live off in your retirement. Your pension’s primary purpose is to provide an income for you in your retirement. By reducing the size of your pension fund, you are effectively reducing the amount you have to live off once you finish working. 

This might mean you have to work for longer or compromise your standard of living in retirement.

Additionally, you could reduce the potential returns your pension pot may see over the coming years, so your retirement fund could be reduced by more than just the cash amount you withdraw.

There are also upsides to paying off debt using your pension

While it is important to be aware of the potential downsides caused by accessing your pension to repay debt, there are also several positives to consider.

Taking money from your pension in order to pay off your mortgage and own your house outright can provide you with an added sense of security. 

Paying off your mortgage early also reduces your regular monthly outgoings. The Office for National Statistics (ONS) found that the average UK household spends 15.7% of their weekly disposable income on mortgage payments. Removing this outgoing could free you up to do other things in your retirement.

Paying off your mortgage could also mean you are not beholden to changing interest rates causing your monthly outgoings to fluctuate. This may reduce the amount of financial uncertainty you face in your retirement. 

Finally, it is possible to save money on interest payments by paying off your debt early. Although, mortgages can sometimes have early repayment fees, so it may be worth discussing this with a financial planner before you make any decisions.

A financial planner can help you to use other methods to pay off your debt

When it comes to paying off your debts using money from your pension, there are many things to consider. This can be a complicated issue, so it may be a good idea to seek the assistance of a financial planner.

We can look at your personal situation and help you to understand whether it is a good option for you, or if ringfencing your pension to provide an income in retirement may be more appropriate. 

If you are considering the best ways to pay off your outstanding debts, please get in touch with us. 

Please note

This article is for general information only and does not constitute advice. The information is aimed at retail clients in the UK only.

Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.

A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future performance. 

The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates, and tax legislation may change in subsequent Finance Acts.  

Your pension income could also be affected by the interest rates at the time you take your benefits. The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation, and regulation, which are subject to change in the future.