When it comes to surplus income or a lump sum, there are a lot of different options. You may want some of it to go towards maintaining your current lifestyle, such as paying for upcoming holidays and expected short-term expenses. Some could go towards paying down debts or investing for the future.

Before considering potential investments, it is sensible to have an easily-accessible emergency cash fund that can cover several months of expenses. Having this cash available can help to cover unexpected costs or a change in circumstances without having to sell some of your investment holdings to create the liquidity you need.

A common topic: mortgage overpayment vs. increasing pension contributions

We will first look at a trade-off many consider: if you have a mortgage, should you overpay it? Or should you instead invest surplus income in financial markets in pursuit of your long-term financial goals? While there are many ways to invest, in this context, we will look at making additional pension contributions and how this compares to mortgage overpayments, as mortgages and retirement planning tend to have particularly long time horizons.

Overpaying your mortgage

Possible upsides:

Increasing your monthly payments is an option for those with surplus income.

• It can reduce your overall mortgage balance quicker, reducing the time you will hold your mortgage for, and as a result lowering the total interest paid.
• It will also increase the equity in your home at a faster pace, which could have benefits when it comes to re-financing.
• Being mortgage-free earlier can also be mentally freeing, as well as offering financial flexibility once you have cleared what is many people’s largest monthly outgoing.

There are, however, other considerations.

Possible downsides:

There is the possibility of early repayment charges. Many mortgages have limits on the amount that can be overpaid per year, and you can be subject to penalties if these limits are breached.

From an investment perspective there are several angles:

• Reduced liquidity – extra mortgage payments are tied up in the equity in your home, which could make your overall wealth picture more concentrated. This can result in less flexibility, which can be restrictive if your circumstances change.
• Lower diversification – considering your overall financial portfolio, concentrating your wealth in your property could leave you disproportionately exposed to property market fluctuations if you came to sell it, rather than being further diversified across financial markets. Some may not consider their property as an investment, but for many it is the largest financial commitment we will make, and should be considered as a key part of your total wealth picture.
• Opportunity cost – paying down debt is prudent, but depending on your mortgage deal and the direction of interest rates in the future, it’s possible your mortgage rate could be outstripped by the return in financial markets. Investment returns are not guaranteed and the value can move up and down. However, it is possible that by investing the money instead, over the equivalent term, it could grow to a larger amount than you would have saved in interest by paying off your mortgage early. This option is riskier, as the return in financial markets is unknown, whereas you can calculate the interest you would be saving by overpaying your mortgage. Markets are unpredictable and returns can't be taken for granted, but it is an appropriate factor to consider, as the power of compounding can be substantial when investing for the long term.

Increasing pension contributions

Saving for retirement is key to a successful long-term financial plan for many. The earlier you start and the more you contribute, the better chance you give yourself to benefit from the effects of compounding. It is well established that pensions can be a highly tax efficient way to use surplus income or lump sums for retirement planning.

If you’re a UK taxpayer under the age of 75, every tax year you may be able to get tax relief on personal pension contributions up to 100% of your earnings (or £3,600 if you have no earnings in that tax year), or on contributions up to the government-set annual allowance, whichever is lower. The annual allowance is currently set at £60,000 per tax year, although if you are a high earner you may be affected by the tapered annual allowance.

Tax relief

Everyone is entitled to basic rate tax relief at 20% from the government when making pension contributions, with those in the higher and additional rate bands able to claim a further 20% and 25%, respectively. The rules for Scottish residents are slightly different.

This tax relief element of pensions is one of their most powerful characteristics. Increasing your pension contributions can be a highly efficient route to investing for your long-term future in retirement, as it helps to harness the power of compounding over time even more. Saving £100 more each month into your pension, if you are a higher rate tax payer, would typically only cost you £60. Being able to contribute more, for less, could help your pension to benefit from potential investment returns even more.

For many, saving for retirement will be through a ‘salary sacrifice’ scheme provided by their employer. One common arrangement involves agreeing to a reduced salary, with the employer contributing the difference directly into your pension. This can increase the value of your pension savings and can also reduce your taxable income, resulting in savings in both income tax and National Insurance contributions.

Using ‘carry forward’ rules to your advantage

In addition to surplus monthly income, you could be in a position where you are due to receive a lump sum. This could be from many different routes, such as a bonus received from work, or a gift. If you have maxed out the annual allowance for the year, you may still have options to contribute more, depending on your circumstances, including your relevant earnings, and your contributions over previous tax years. You could take advantage of pension carry forward rules, which allow you to receive tax relief on any unused portion of your annual allowance from the previous three tax years, as long as you were a member of a pension scheme during those years. This can be particularly useful if you’re self-employed, or if you’re looking to make particularly large pension contributions, which might be the case if you receive a lump sum.

It is worth noting that, with potential restrictions and penalties around withdrawals, solely dedicating your surplus income to your pension could leave you with more limited flexibility when considering your wealth picture as a whole. Balancing investments across a range of products, such as ISAs and JISAs, can provide a balanced, flexible overall wealth portfolio. We will discuss these products more later.

Please note that the level of tax relief depends on individual circumstances and is subject to change.

For an in-depth overview of pensions and retirement you can read our guide.

Finding balance

Whether you consider one of these options, a combination of both, or neither, will partially come down to personal preference. We see taking a diversified approach to your overall wealth picture as an important consideration.

It is important to remember that circumstances can change and unexpected events happen, meaning that having some flexibility can be advantageous. As mentioned, only overpaying your mortgage could leave you with your wealth highly concentrated in your home, while solely focusing on pension contributions could leave you with tight restrictions around accessing your money, and therefore lower flexibility.

If you are seeking greater flexibility and a more diversified overall wealth picture, then combining these options with a balanced approach across other products as well, may be more appealing.

Products such as ISAs and JISAs can play a prominent role. While investments held in Stocks and Shares ISAs should still be considered for the long term, they typically offer more direct access to your money than a pension.

If you would like to speak to us about how best to find the right balance for you, we offer ‘restricted’ advice. This is a paid service that will involve fact-finding conversations with your wealth adviser in order to provide recommendations that are tailored to you. ‘Restricted’ means we only make investment recommendations on the products and services that we offer.

Risk warning

As with all investing, your capital is at risk. The value of your portfolio can go down or up and you may get back less than you invest. Pension/ISA/JISA eligibility rules apply. Tax rules vary by individual status and may change. This is general information, not personalised tax advice. Seek financial advice if you're unsure if a pension is right for you.