Should you use your pension to pay off your debts?

More people than ever are retiring with significant amounts of debt. One in three people planning to retire now expects to have debts – an average of over £17,000.

And annuity rates have been low for a long while, although they should be starting to rise as interest rates edge up in 2022. So with more debt to pay and their likely pension income getting less, it’s not surprising that many people are thinking of taking money from their pension rather than take it as an annuity giving a monthly income. This has been possible since 2015 if yopu are over 55. From 2028 this age will increase to 57.

This could give you a new way to repay your mortgage or other debts. But is it a good idea?

There are possible tax and benefits problems involved, the charges could be bigger than you expect. And there is the big issue that your pension is meant to fund a comfortable retirement!

Who can now take money from their pension?

Most people with a personal pension (sometimes called a “money purchase pension” or a “defined contribution scheme”) can now withdraw some or all of it all in cash when you get to 55 or over. Even if you are still working.

Who can’t?

the under 55’s. Don’t believe anyone who says you can get money from a pension if you are under 55 – they are either mistaken or this is a scam;
people who are already getting a pension from an annuity – you can’t change it and take cash instead;
people in a final salary scheme can only take money out if they first transfer it into a personal pension and then access it. This may be VERY poor value for money. And you are taking on a lot of risk. If the transfer value is more than £30,000 you will have to pay for independent financial advice first before you do this.

The rest of this article assumes that you can access your pension money if you want and looks at whether this is something you should do to help tackle a debt problem.

“Great – so I will be able to pay off my debts!”

That is quite a common reaction – in 2015 after the new rules came in pension providers reported that repaying debt was the most frequent reason people gave for withdrawing money.

If you are paying 20% or more interest on credit card debt, seeing a pot of your money locked up in a pension and then being forced to use most of it to buy an annuity which will give you little income can be very frustrating. But most people have to be very careful about spending too much too soon – you will still need your pension to fund a comfortable retirement even if the mortgage is paid off. And it’s easy to underestimate how long you might live – 1 in 3 men aged 65 will live to be over 89 so you may be retired a lot longer than you think!

How good are you with big money decisions?

For people who are good with money and who have considerable savings, the new rules provide a lot more freedom. But if you aren’t comfortable with making long-term financial plans and sticking to them, this new freedom can be dangerous. The old pension rules encouraged you to put money away for your retirement and also protected you from making the ‘bad’ decision to raid that money for living expenses whilst you are still working.

If you take money from your pension pot to clear your debts or a mortgage, you may be swapping a current debt problem for a much bigger problem of too little income in retirement.

The five big problems with taking money from your pension

The biggest problem with taking money out is that you won’t have enough money when you retire. But if you are sure that you will, you still need to check out these five major factors that could make it much more expensive to take money out than you might expect:

charges There may be high “early encashment” charges if you take money out before you retire. There can also be extra charges are for each withdrawal.
benefits Any means-tested benefits such as ESA and Universal Credit may be reduced, sometimes to zero, if you take a lump sum from a pension. This is a major danger if you intend to give the money away, perhaps to your son or daughter to clear their debts or as a deposit, but it may even happen if you use the money to repay your own debts. The DWP has announced that you have to inform it and your local council if you take any money from your pension and you are getting benefits. This article looks at the topic in more detail, but you need advice on your own situation – go to your local Citizens Advice and ask about the interaction between pensions and benefits;
tax 25% of the amount you take out will be tax free, but the rest will be added to your income this year. This may push you into a higher rate tax band so the tax could be a lot more than you expect – use this calculator to see how much tax you will have to pay. It may be better to take some money now and then some more in the next tax year to reduce the tax you will pay;
“recycling rules” If you want to take over £30,000 out, check the little-known Pension Recycling rules as these can impose an enormous extra tax charge of 70%;
final salary If you have a final salary scheme, changing this into a personal pension and taking cash out may be at a poor “conversion rate”. And you will lose not just retirement income, but a measure of inflation-protection, life assurance before you retire and a spouse’s pension as well.

Who shouldn’t take cash from their pension

Here are some situations where using pension money to pay debts would probably be a mistake:

if you just have a temporary problem, eg because of coronavirus. It may be better to take mortgage holidays or ask for payment breaks for your debts for a few months. If you take money from your pension you may be turning a short term difficulty into a long term problem;
cutting back on your expenses and/or looking for 0% balance transfer offers could clear the debts in a few years, then this is a better option;
if you are in a DMP where interest is frozen and the debts are falling nicely then stick with this;
if you want the cash to help someone else, eg clear your child’s debts or help them with a deposit to buy. Unless you are financially well off and you are sure your pension arrangements will be good without the cash you want to withdraw, you shouldn’t be considering this.

Some decisions won’t be easy:

is your house larger than you need? Downsizing now could free up money to clear debts, give you a lower (or no?) mortgage, and reduce running costs such as council tax, utilities and longer-term house maintenance. Don’t lose your retirement income trying to cling on to a big property;
if uncomfortable options such as a lodger for a few years or a second job would make a big difference. Some temporary inconvenience now could leave you in a much better position for decades afterwards.

Withdrawing money from your pension will not be speedy. This varies between a few weeks (if you don’t have to move your pension somewhere else) and several months (if you have to switch out of a final salary scheme first). The tax taken off may be higher than it should be and you have to reclaim the difference from the taxman.

If you fancy the idea of being able to take money from your pension when you need it and leaving the rest to grow tax-free (which sounds seductively nice, doesn’t it?) then you need to look very closely at the costs involved. For small pensions pot, the costs of doing this can be extremely high – as this article says “For many with funds of £50,000 or less and few other assets in retirement, a traditional annuity is probably still best.”

Who should consider taking this pension cash

There will be some people with debts for whom this new option is potentially very useful:

if you are in a failing IVA. In this case being able to get some cash to propose an early settlement could be a good option (NB don’t take the cash out without first getting agreement from your IVA firm in writing about an early settlement);
if you are in a low payment DMP and have too much equity for bankruptcy, you could use money from your pension to propose a full and final settlement to your creditors;
if you have a secured loan at a very high interest rate, you may be desperate to clear it;
if you have an interest-only mortgage about to end and you can’t repay it. It would have been better to have made other plans to deal with this, but if you haven’t, then being able to get at the pension cash may help;
if you also have a good final salary pension, you may be relaxed about using a small defined contribution pension to clear debts as you won’t need an income from that pension when you retire.

I am sure there will be other situations where accessing pension cash early to solve a debt problem is a good idea. But probably not that many.

So is it a good idea for your debts?

As a general rule you should look at all your other possible debt solutions that won’t impact your pension before considering withdrawing cash. You will probably have 20, 30 or more years of retirement – that’s a long while to live with a reduced income.

If you are already in debt management, in a DRO or IVA or bankrupt, or you are considering one of these, then find out how it is affected by the pension changes:

If you are being harassed by creditors or are worried about bailiffs there are other options that can help. Don’t be rushed into the wrong decision, especially not one that is irreversible such as taking money out of your pension. Read about alternative ways of tackling debt and then talk to National Debtline or StepChange about which ones could suit you.

Book an appointment with PensionWise

The government has set up Pension Wise to help you understand what your pension choices are. This includes a telephone-based service and face-to-face advice. You can book a Pension Wise appointment by calling 030 0330 1001. If you are mainly interested in accessing money to clear debts, also ask for a second appointment with Citizens Advice to cover what alternatives you might have for your debts.

Be alert for scams!

Since these new ” pension freedoms” there has been a massive increase in the number of people being cold-called or texted about pensions. Many of these are scams! Reputable companies do not contact you like this. Look out for the phrases scammers often use: ‘one-off investment opportunities’, ‘free pension review’, ‘legal loopholes’, ‘cash bonus’ and even ‘government endorsement’. Be especially suspicious if the opportunity being offered involves something overseas – one pension company has said 80% of the foreign transfers it has looked at are scams.

*** This article is kept updated with the latest links ***

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