Nearing retirement still owing money is a daunting prospect but there are ways to use it to your advantage.
Debt can be a four-letter word at the best of times. But for the growing number of people approaching and entering retirement still owing money, it can be a nightmare.
One consideration often overlooked is how debt affects your age pension entitlement. Colonial First State executive manager, FirstTech, Deborah Wixted, says many people don't realise that different types of debt are treated differently under the pension means tests. If you're approaching pension age and trying to get your finances organised, she says it's important to manage your debts to get the maximum age pension buck (see also Page 9).
Wixted says the critical question for age pension purposes is what is the loan secured against? That's different to the tax laws which look at what the money was borrowed for.
So if you have drawn equity down against your home to fund an investment, you may be entitled to claim the interest expenses in your tax return.
But when it comes to assessing your age pension entitlement, Centrelink will look at the security for the loan.
Wixted says this is important to plan for as borrowings secured by your home don't reduce your assets or income for the pension means tests. Because the family home is exempt from those tests, borrowings against it are disregarded.
However, loans secured by investment properties reduce both the value of the property for the pension assets test and the income you receive from rent.
Wixted uses the example of Col and Cassandra who are both five years out from age pension age. They have a $500,000 home with a mortgage still owing of $200,000. They also owe $200,000 on an investment property valued at $400,000 and have $150,000 each in super and home contents worth $20,000.
They have enough cashflow to repay one of their loans before retirement. Both loans are charging interest of 7.3 per cent and the investment property has a rental yield of 3.5 per cent.
If they use their cashflow to pay off their investment loan, Wixted says they will reach pension age with $871,273 in assessable assets - their account-based pensions which will have grown to a combined value of $510,900 thanks to earnings and further compulsory super contributions, and the investment property which will be worth $440,373 assuming growth of 5 per cent a year.
Under the assets test they will be eligible for a combined pension of $5709.
But if they had used their cashflow to pay off the home loan, the picture would be quite different.
While their assets would still be worth $871,273, Wixted says the $200,000 still owing on the investment loan would be deducted from the value of the investment property, bringing their total assessable assets down to $671,273. That would give them a combined pension of $13,509 - or an extra $150 a week.
Under the income test, Wixted has assumed the couple receive a combined income of $27,700 when they reach pension age - $12,288 from their pensions assuming a 9 per cent drawdown, and rent of $15,413. If they had paid off their investment loan, this income would be fully assessable, resulting in a pension entitlement of $18,936.
But if they still had the investment loan, the interest of $14,600 would be offset against their income to give them assessable income of $13,101 and a combined pension entitlement of $26,236.
Because Centrelink uses both tests to decide how much pension you get, Wixted says Col and Cassanda would only be eligible for the lower pension figures determined by the assets test but there is still a substantial benefit to be gained by paying off the home loan first.
Wixted says personal debts such as credit cards and margin loans against financial assets are also treated differently for Centrelink purposes.
While you can offset the amount of any margin loans against the value of those investments, Wixted says interest on these loans does not reduce your assessable income.
Unsecured debts such as credit cards are ignored completely for both tests, regardless of what you have used the money for, because no security is put up.
Wixted says people nearing retirement should generally try to pay off their unsecured debts first, followed by their home loan, then margin loans and property investment loans last.
"You don't get any "value" for Centrelink purposes from [unsecured debts and] the mortgage," she says.