Key Post Continue with AVC's or pay extra off buy to let mortgage?

I am paying €1200 p/m in avc's and have accumulated nearly €200k over the years.The tax relief means this is costing me around €708 p/m.
I have €120k outstanding on a buy to let mortgage. It's a variable rate and is costing a grand a month against a rent of only half that.
Would I be better off paying the extra €708 p/m off the mortgage and try and reduce it? Thanks.

You should really provide the Basic information required for the "Money Makeover" forum
if you post in this forum

You should provide it anyway to answer a question like this.

So many other factors are relevant - the interest rate; whether you own your own home and whether you have a mortgage on it.

It can't be answered in isolation

Brendan

Apologies.We don't have a mortgage on our own home and the variable rate interest rate on the buy to let is 4.85%.
My wife is a national school teacher on the top of her pay scale earning €65k.
I work in the private sector earning €70k.
Children all done for so we realise we are in a fortunate position compared to many, many others.I have a defined benefit pension scheme at work but will only have 31 years service out of 40 when I retire at 65. I am 53 now and my wife is 52.

I am not sure which is the best. This is how I would look at it.

The net cost of the mortgage interest is 3% (4.85% less tax relief @75% @50%)

So if you put €100 against your mortgage, you will get a real return of 3%

If you put €100 into your pension, is the net return after fees and taxes likely to be in excess of 3%?

€200 contribution
€100 tax relief
€100 net cost

If it's invested in equities , let's say it will grow at 6 % a year which is pretty ambitious after the heavy charges of pension funds. (It will grow tax-free within the fund)

When you retire, you will pay tax on the pension probably at your top rate - say 50%( I suspect that you will have used up the tax free element by then, so further contributions are taxed at 50%)

You get the €200 back less 50% tax = €100

You get the €6 back less 50% tax =€3
Correction to original post - 6% of €200,000 = €12 less 50% tax = €6


By paying down the mortgage, you are guaranteed a net return of 3%. In fact, it will probably rise as interest rates are expected to rise.
It seems to me that you are getting a net return after charges and tax of 6% from a pension scheme.

For these calculations, I have assumed a 6% return after charges from the pension fund. It could be -6%; it could be 3%; it could be 10%. No one knows. And this is the most important factor in the decision.

The future taxation of pensions is very uncertain. This government introduced a retrospective tax on pensions and may do so again in the future.

You are tied into your pension for another 10 years or so and anything could happen over that period.

Paying down the mortgage is the most flexible. For example, if you are in negative equity, getting rid of the negative equity, means you will be able to sell it if that is what suits you. If it's in negative equity, the lender may not allow you to sell it.


Paying down the mortgage is the least risky option.

That's brilliant Brendan, thanks a million.

Hi bakothehill

It's a complex question which is why I said

I am not sure which is the best.

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I would like to see others either confirming my calculations or challenging them. In fact, on looking at it again this morning, I have changed the calculations.

Brendan

I do hate to complicate this further.

First of all, I do broadly agree with Brendan's assessment of the net of tax investment arithmetic.

You get 41% relief on the way in and pay 52% on the way out assuming current tax rates, PRSI and USC continue to apply. So to begin with tax is actually a negative - one of the great marketing gimmicks is that pension provision is heavily tax subsidised - it is true up to a point, but you seem to be beyond the point where you would be getting tax subsidised lump sums or paying tax on your marginal pension at lower than top rate.

There is of course the tax free roll up within the fund but again I find this underwhelming. The way I look at it, and I presume you are broadly free to chose your type of fund, for a proper comparison with mortgage lending you should consider a bond fund or even a cash fund. Even with no tax, after charges you'd be lucky to earn 2% p.a. so yet another reason to shun the AVC route and pay down the mortgage. Of course, with still a bit of time left to run most financial advisors would recommend investing in a managed or equity style fund. But you should note that this is essentially a gearing decision much like Endowment Mortgages and most commentators these days frown on these. So no compelling investment reason to keep making those AVCs.

But now we come to probably the most difficult aspect of the choice.

Under current pension rules, and presuming your scheme is not an exception, your AVCs must be received by way of pension - not by way of lump sum, as this is already covered. Exactly how much pension you get for your AVCs will depend on your scheme but it does generally tend to be good "actuarial" value i.e. you get a higher pension than you could buy in the market. Okay so that is one up for the AVCs but you face a very difficult what we call in the game "utility" choice, let me explain.

Let's say you are faced with a choice of 100K in your pocket at age 65 or a pension of 5k p.a. for the rest of your life. An actuary might tell you jump at the 5k p.a. But think about it, after you consider the interest you might earn on the 100k you will probably be 90 before you can sit back in your nursing home and pat yourself on the back (if you can reach) at having made a shrewd call all those 25 years ago With the 100k in the hand of course you have so many more options, your call.

Your position is also slightly complicated by the fact that your wife is in the public service. My recollection is that they have fairly attractive AVC arrangements though again I think they come in the form of enhanced pension and so back to that utility question.

Hi Duke

Thanks for that additional commentary.

When I started answering this question, I was thinking that the pension was the better option. I swung towards paying down the mortgage as I wrote the answer. Now I am fairly sure that paying down the mortgage is the right approach.

Exactly how much pension you get for your AVCs will depend on your scheme but it does generally tend to be good "actuarial" value i.e. you get a higher pension than you could buy in the market.

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I had assumed that he could put the AVCs into an ARF or take them out and pay top rate tax on them? If he has to buy an annuity, that would be another argument against contributing to a pension.

Why do you say that they are good "actuarial" value?

Brendan Burgess said:

Hi Duke

Thanks for that additional commentary.

When I started answering this question, I was thinking that the pension was the better option. I swung towards paying down the mortgage as I wrote the answer. Now I am fairly sure that paying down the mortgage is the right approach.



I had assumed that he could put the AVCs into an ARF or take them out and pay top rate tax on them? If he has to buy an annuity, that would be another argument against contributing to a pension.

Why do you say that they are good "actuarial" value?

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subsequently corrected

Brendan Burgess said:

Hi Duke

Thanks for that additional commentary.

When I started answering this question, I was thinking that the pension was the better option. I swung towards paying down the mortgage as I wrote the answer. Now I am fairly sure that paying down the mortgage is the right approach.



I had assumed that he could put the AVCs into an ARF or take them out and pay top rate tax on them? If he has to buy an annuity, that would be another argument against contributing to a pension.

Why do you say that they are good "actuarial" value?

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You are right. I'm a bit rusty, they did change the rules to allow one to ARF AVCs.

The scheme commutation factors are usually geared at those who are converting pension to lump sums and are constructed to be "bad" actuarial value for them. As OP would be going in the opposite direction, if he chose not to ARF, he would be getting "good" value. Thus the actuarial advice would normally be buy back years rather than go the ARF route, but we are right up against the utility call.

This is great all, really appreciate the feedback.The whole point in me contributing a large amount into my company avc fund ( state street actively managed), apart from the tax saving going in, was that I thought I could use it to get my maximum lump tax free out on retirement and not take any lump sum out of my company defined benefit pension at 65. As I stated I will only have 31 out if 40 years in at retirement anyway so I wanted to keep the monthly pension as high as possible ex lump sum.
The one thing I'm not sure of is the limit of the tax free lump sum? Is it 1.5 times my final salary or is it say €200k or something.
There's also the fact that the government may reduce the tax incentives further for top rate tax payers in the upcoming budget. Maybe equalise the rate of relief at 30% or even put all reliefs at 20%.

backothehill said:

There's also the fact that the government may reduce the tax incentives further for top rate tax payers in the upcoming budget. Maybe equalise the rate of relief at 30% or even put all reliefs at 20%.

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If you choose to continue making AVCs and the government decides to change the tax treatment, then you can stop making AVCs.

The problem with pensions is that they are long term commitments and inflexible. So it would have made good sense to you some years ago to max the AVCs as there was no (effective) limit on the tax-free lump sum. But that was reduced to €200k in Jan 2011. [broken link removed]. It is probably not worth contributing to a pension where the €200k target has already been secured. And of course, this may be reduced further but your money will have been committed already.

I think it's more likely that the government will reduce the tax relief on interest paid on residential property investment.

If they reduce both, then you would be hit by a double whammy. You would be getting less tax relief on the money already contributed to your pension scheme and you would be getting less tax relief on the higher interest which you are paying. Paying down the mortgage instead of contributing AVCs seems like the best way to protect against changes in tax policies.

backothehill said:

There's also the fact that the government may reduce the tax incentives further for top rate tax payers in the upcoming budget. Maybe equalise the rate of relief at 30% or even put all reliefs at 20%.

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That would be an argument for making the contributions now while tax relief at the higher rate is available.

If the government reduces the tax relief to 30%, it will not be attractive to higher rate tax payers who will be getting tax relief at 30% on the way in only to pay 54% on it on the way out. I do think that the civil servants who had proposed this have finally seen how stupid it would be.

backothehill said:

This is great all, really appreciate the feedback.The whole point in me contributing a large amount into my company avc fund ( state street actively managed), apart from the tax saving going in, was that I thought I could use it to get my maximum lump tax free out on retirement and not take any lump sum out of my company defined benefit pension at 65. As I stated I will only have 31 out if 40 years in at retirement anyway so I wanted to keep the monthly pension as high as possible ex lump sum.
The one thing I'm not sure of is the limit of the tax free lump sum? Is it 1.5 times my final salary or is it say €200k or something.
There's also the fact that the government may reduce the tax incentives further for top rate tax payers in the upcoming budget. Maybe equalise the rate of relief at 30% or even put all reliefs at 20%.

Click to expand...

The lump sum rule is 1.5 times final salary, you cannot take more than that. The 200K is the amount of this lump sum which is tax free, the next 375K is taxed at standard rate. "Final salary" can include an average of your last three year's bonuses and other BIK but it would seem that you have already well exceeded your lump sum capacity with your AVCs. Any further AVCs are not going to enhance your lump sum. Instead you already have a surplus of AVCs which you will either need to transfer into an Appoved Retirment Fund, take as Cash (both subject to full tax, USC and PRSI) or buy back years for your pension if your scheme allows it. Given your stated objectives for making AVCs in the first place it no longer seems to make sense for you to continue to do so and that is irrespective of your mortgage.

As a separate investment decision it does seem to make sense to pay down your mortgage.

It is a fairly complex area with many technical as well as life choice complications. Just for completion it should be noted that ARFs have certain inheritance tax advantages. The Revenue has booklets on the subject.

I personally think there is enough in this thread to inform your decision but some would suggest that you should take professional advice. If you do, make sure it is a full fee paying service you go for, but be warned the fees ain't cheap. As I say I don't think you need go to those lengths and in any event so many things can change that there is no definitive right or wrong answer.

There is another line of enquiry that needs exploring here around the rental property itself. Can I ask the OP how much did they pay for the property originally?

€168,000 was the purchase price of the rental property in 2005, we took out a €129,000 mortgage of which there is about €120,000 outstanding. There is about €6k coming off the capital annually at the moment as a consequence of the variable rate annuity mortgage.

Thanks Duke for that.

This is a great planning question with some excellent analysis. Thanks for bringing it to our attention Brendan.

Based on the rental income that I assume is 500pm I would value the property for investment purposes at between €72,000 and €84,000 based on nothing more than a reasonable multiple of the rent of 12 to 14 times. The OP states that they paid €168,000 in 2005.

With an outstanding mortgage of €120,000 this is clearly a negative equity position.

So, in an ideal world the optimum solution might therefore be to hand the keys to the property back to the bank and walk away.

However, for various reasons this might not be practical or desirable but to get as close to this as possible to that outcome would further support the logic of debt repayment over AVCs.

The analysis could be enhanced by applying the following logic:
Repay loan out of net income until debt equals sale price of property for ease of maths and in the absence of a market appraisal lets say this is €100,000.

So, lets imagine a world where the OP has just won 120k on a scratch card what should they do?

Most people looking at the above analysis would say repay the loan in full and keep the investment property. But this assumes that this particular property is the best investment the OP can make anywhere in the world at anytime - which almost certainly won't be true. As investors we tend to suffer from an " endowment bias" we view our present position and the status quo as an optimum position for the purposes of analysis of our options.

In principle whilst I agree that the most efficient use of savings is debt repayment I would suggest that this is possibly only true to the point at which the debt equals the net sale proceeds of the property.

Once the debt is reduced to the point at which a sale would clear the remaining debt, the op should seriously consider selling the property as a relevant option. However, this would be an extremely difficult emotional decision for many people to make.

Let's say that the op makes debt repayments of say 20k and could then sell the property for 100k and clear the remaining debt they would crystallise a capital gains tax loss of around 68k based on the purchase price .

They could then invest their future savings, tax free lump sums in retirement and any other capital in a globally diversified portfolio taking considerably less risk than a single investment property and until they had made gains equal to the 68k CGT loss, and if the new portfolio was appropriately structured, they would have very little tax to pay on their new investment portfolio.

This would be more tax efficient than making additional AVCs and less risky and probably considerably less work and hassle than holding a single investment property.

Its like the old joke about how to get to Kerry, you wouldnt want to start from here but since this is where you are, you should focus on where you would like to get to more than where you are starting from.

Lol Marc! That is tremendous..You guessed correctly on the house value, about €100k...based on what I've learned this bank holiday I'll make a move to reduce my avc contributions to the minimum, say €50 p/m and arrange to pay an extra €600 p/m off the mortgage.
You guys are top class. There is one other thing but I'm afraid to mention it because Brendan might tell me off for not saying it at the start...We have another investment property in Dublin in negative equity as well. Bought for €460k with a mortgage of €360k, interest only for 5 years, now on repayment but thankfully on a tracker. This means the payments are now 1750p/m at the moment with a rental income of 1300p/m...The reason I haven't been as concerned about this one is the tracker. I know I'm dumping hundreds a month to keep it going but what the hell, I'm o e of many. In a perverse way I'm more exorcised by the 120k variable rate property, deal with that and then look at the big one. I'm at leased soothed by the prospect that the interest rate can't go too mad on the tracker...Of course some genius's are suggesting that the government should put a levy on trackers as they are "not fair"..Dear o dear!