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Using your pension to pay off debts

You need to think carefully before taking money from your pension pot to pay off debts. Money you take from your pot now could leave you with less to live on in future.

The impact of using money from your pension to pay off debts

You might be thinking about getting access to the money in your pension to help you sort out your financial situation.

It is possible to use your pension to clear debt.

But taking money out of your pension could leave you in a worse position than you expected.

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Before you take any money out, you need to know what the effects might be now and in the future.

Three important things to think about are:

  • the impact on your future income from your pension
  • the impact on your State benefits
  • the impact on your tax position, both now and later.

Impact on your pension

Defined contribution pensions

If you have a defined contribution pension pot, and you take money from your pension pot to clear debt, you’ll have less money in your pot to give you an income when you retire.

You will normally need to be 55 before you can begin taking money out of your pension.

Your options for how to use your pension pot when you retire might also be limited.

While it might be convenient to take the money out of your pension now and use it to pay off debts, you won’t have that money in your pot to use in your retirement.

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Defined benefit pensions

If you have a defined benefit pension, such as a final salary or career average pension, you don’t have a pot of money you can withdraw from. It may be possible to begin receiving your income from the pension early. This could allow you to make payments towards clearing off your debts, but you’ll usually receive a lower income because it will potentially need to pay you an income for a longer time.

It may be possible to begin receiving your income from the pension earlier than the normal age under the scheme, though not usually before age 55. It does not usually provide good value for money to do this. It will generally mean sacrificing long term security for short term gain so you should think very carefully before looking to do this.

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Impact on benefits

Some benefits are based on the income you have coming in, and the amount of savings you have.

So if you take money from your pension to pay off debts, it might reduce the amount of money you can get from benefits both now and in the future.

Even if you use the money you take from your pension to pay off debts, the payment of some benefits is still affected.

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Impact on tax

Taking money from your pension can have an impact on how much tax you pay, and the tax relief that you get.

Usually, 25% of your pension is paid to you tax-free. The remainder will be subject to tax. This 25% tax-free figure is often known as a pension lump sum and can be used to pay debt if you decide that is right for you.

But cashing in your pension to pay off debt might leave you with a large tax bill that you weren’t expecting, and the amount of tax you pay reduces what you’ll get from your pension pot.  

If you take money out of a defined contribution pension pot above the 25% tax-free part, you could also be affected by the Money Purchase Annual Allowance (MPAA). 

If you are affected by the MPAA, this means that the amount that you (and your employer, in a workplace pension) can contribute to your pension pots with tax relief applying is limited to £4,000 each year.  

If you’re not limited by the MPAA, you might be able to get tax relief on pension contributions on the lower of 100% of your earnings and £40,000 each year (the Annual Allowance).

Arrangements to pay your debts

If you have an arrangement to pay your debts, your creditors might be able to take money from your pension income or lump sums.

This includes money or income from:

  • an annuity or scheme pension (such as a final salary or career average pension)
  • a pension drawdown fund
  • any lump sums you take
  • taking your whole pot in one go.

Find out the status of any debt arrangement you have before choosing a pension option.

Bankruptcy

Many people declare themselves bankrupt each year.

Bankruptcy can help when you’ve got large debts that would normally take years to pay back.

However, being bankrupt can have serious implications for your future, both personally and financially.

It’s a decision that needs careful consideration, and we recommend you get financial advice before making any decisions.  

Most pensions aren’t included as assets in your bankruptcy.

This means they can’t be claimed by the person appointed to manage your bankruptcy – known as your ‘trustee’ – if you don’t take money out of your pension.

If you do take income or lump sums from your pension, your trustee might ask you to make regular payments towards your debts from that money.

They can also claim an entire lump sum if you take one while you’re bankrupt.

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Bankruptcy before 29 May 2000

If you became bankrupt before 29 May 2000, the government’s Official Receiver would have taken control of your assets.

They would then have passed them over to something called a Trustee in Bankruptcy (TIB).

The assets held by the TIB will then be used to pay off your creditors.

Retirement benefits are viewed as an asset and will be included in this.

Forfeiture clauses

Many workplace pensions include what’s called a forfeiture clause in their scheme rules.

This protects your pension benefits if you’re declared bankrupt before you were entitled to receive your benefits.

A forfeiture clause is designed to pass the pension rights to the scheme trustees/administrators, rather than leave them as part of your estate.

If you’re declared bankrupt and your scheme has a forfeiture clause in it, while you would have no further rights under the pension scheme, your assets would come under the control of the scheme trustees.

Your scheme trustees could use their discretion and pay the benefits when they became due to any beneficiary, including to you or a spouse.

Pensions already being paid

Where a pension is already being paid out, a Trustee in Bankruptcy (TIB) can apply to the court for an income payments order. This is under the terms of the Insolvency Act 1986.

This order means you have to contribute towards paying off your debts, from your pension payments.

You might have to do this for a maximum of three years.

This is subject to you and your family being left with sufficient income to live reasonably, after any deductions have been applied.

This can continue to apply even when you’ve been discharged from bankruptcy.

Bankruptcy on or after 29 May 2000

If you have workplace pension scheme benefits, personal pension scheme benefits, stakeholder pension scheme benefits or Section 32 benefits which you’re not yet taking, and are declared bankrupt on or after 29 May 2000 – you’re protected against any claim by the Trustee in Bankruptcy (TIB).

A TIB can, however, apply to the court to recover what they would consider ‘excessive contributions’ paid to the pension scheme.

You might be seen to have paid excessive contributions. This is especially true if you’ve paid in unusually high levels of contributions and they can prove that you’ve done this to deliberately deprive your creditors of money owed. This could cover any contributions paid up to five years before your bankruptcy.

It’s also possible for you to make an out-of-court agreement with the TIB, to pay over a part of your pension for a set amount of time.

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Looking for us? Now, we’re MoneyHelper

MoneyHelper is the new, easy way to get clear, free, impartial help for all your money and pension choices. Whatever your circumstances or plans, move forward with MoneyHelper.

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MoneyHelper is the new, easy way to get clear, free, impartial help for all your money and pension choices. Whatever your circumstances or plans, move forward with MoneyHelper.

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