Continuing in our series of questions linked to Financial Planning, this quarter’s question concerns pension linked borrowing.

Question:

I heard that it is possible to use a pension scheme to save for paying off a business loan and that this was tax effective. Is this the case?

In some circumstances - yes.

Firstly, it is necessary to understand the basics.

There are two main types of business loans:

1. Interest only

   With this type of loan, the instalment you pay every month consists wholly of interest. At the end of the loan period, you need to repay the whole original loan.

   You get tax relief at your highest rate on the full interest payment every month.

2. Interest and capital

The payment you make every month consists of capital and interest. As the life of the loan progresses, you pay less and less interest until towards the end of the life of the loan, your instalment consists almost wholly of capital.

Towards the beginning however, your instalment will consist mostly of interest.

You get tax relief on only the interest part of the instalment.

At the end of the loan life – the loan has been paid off.

The interest only loan is the type of loan that could benefit from a pension scheme.

Here’s how it works:

1. You make interest payments on your loan every month and get full tax relief.
2. Simultaneously you make pension contributions on which you also get full tax relief.
3. At the end of your loan (which should coincide with the date you can start drawing on your pension – age 50 for most people) you use the tax free cash from your pension (25% of the accumulated fund) to pay off the loan.
4. As an added bonus, you now have a pension to see you through retirement! (However, do bear in mind that part of your retirement fund will have been used up to pay off your loan).

It is vital to get professional advice as not doing so could land you in significant difficulty if your tax free cash is not enough to pay off your loan.