Personal Finance: Plumping up pensions

Financial Makeover: NAME: ROBERT & SYLVIA HORGAN AGE: BOTH 55 OCCUPATION: DEPUTY HEAD AND HEAD TEACHER

Robert and Sylvia aim to retire at 60. They have a joint net income of about pounds 4,400 a month and they would like to continue their lifestyle in retirement. This does not mean they need to earn as much: a considerable part of their expenditure will cease at retirement, including their mortgage payments and support for one of their three children at university. In all, their target net income is pounds 3,000.

The house, contents and cars are worth about pounds 190,000 and the rest of their estate includes a small portfolio of less than pounds 10,000, made up of cash, a PEP, an ISA and Alliance & Leicester shares. If both work until 60, there will be tax-free cash of pounds 100,000 in today's values from their pensions. This will boost the estate to pounds 300,000 in today's values.

Their combined pension income will be about pounds 33,625 gross and the Horgans are making additional top-up pension payments into an in-house scheme with the Prudential. These will further boost income but will not add to the tax-free cash.

The adviser: Jon Briggs, associate director at Chartwell Investment Management, fee-charging independent financial advisers, 9 Kingsmead Square, Bath BA1 2AB (01225 321700).

The advice: Both the Horgans are members of their teachers' occupational pension scheme, which is based on 1/80th of an employee's final salary multiplied by each year of service.

Based on current salaries and proposed retirement ages, the gross income from Mr Horgan's pension will be 36/80ths of pounds 48,000, or pounds 21,600 gross, plus a further pounds 1,453 from the top-up scheme. Mrs Horgan's will be 26/80ths of pounds 37,000, or pounds 12,025, plus pounds 1,298 from the top-up.

The couple's combined total annual pension at age 60, based on various assumptions (including Mrs Horgan's break from employment to bring up her children, which reduces her basic state pension at age 60) will be about pounds 32,400 net of tax, a few thousand short of target.

This will easily be made up from the pounds 100,000 tax-free cash. And Mr Horgan will get his own basic state pension from 65.

The decision on whether to pay off a mortgage will be determined by Mr and Mrs Horgan's attitude to risk. Also, they are both higher rate taxpayers and the after-tax return they are getting on any investment income will certainly not be as high as the mortgage interest they are paying, particularly as they describe themselves as "conservative" investors. Before paying off the mortgage, I recommend that they concentrate on paying off the car loan, because this will charge significantly more interest. It is first best to check there are no penalties for early redemption.

Further ahead, it would be useful if both of them could take advantage of the ability to invest pounds 3,000 each into a cash Mini-ISA this tax year. If they continue to invest the maximum into this ISA every year they will have accumulated pounds 7,000 each in a tax-free fund that could be used in the event of emergencies.

As for the pension top-up scheme, or additional voluntary contribution (AVC), the couple are both paying just under 7 per cent of salary into the AVC. Premiums are taken directly from their income, giving instant higher-rate tax relief on these investments.

Acknowledging the fact that they will both be basic-rate taxpayers in retirement, these AVCs are a very good deal - they get higher-rate tax relief on the way in, but only get taxed at the basic rate on the income.

But there are several other issues it is important to cover, such as the inability to take any of the AVC money as tax-free cash and the possible affect of a higher pension income on the age-related allowance. There is also the subject of the Horgans passing their estate on to their children.

The age allowance trap is a problem that may be encountered by Mrs Horgan - Mr Horgan will not qualify for an age-related allowance at 65 due to the level of his pension income. People who are 65 or more qualify for a higher personal income tax allowance.

However, this is progressively reduced if the person's income is over a certain limit, which, this tax year, is pounds 16,800.

The amount of extra age-related allowance is reduced by pounds 1 for every pounds 2 of total gross income over this pounds 16,800 threshold until it is brought back to the normal allowance (pounds 4,335 in 1999-00).

Anyone whose income strays above the tax threshold could suffer tax at an effective income tax rate of 34.5 per cent on a portion of his or her income. Eventually, this could affect Mrs Horgan, and it would be as well if she curbed her pension income by reducing payments to the AVCs so that she is in more control of how and when she takes income in her retirement.

Suffering income tax at a marginal rate of 34.5 per cent would negate most of the advantages of getting higher-rate tax relief on the AVC contributions. If Mrs Horgan started investing money into a corporate bond ISA instead of the AVC she may be better off in the long term, as far as income tax is concerned.

There is also the benefit that the money in the ISA could be passed on to her children when she dies. If Mr and Mrs Horgan were serious about passing as much on to their children as possible then they would be better off not paying into the AVCs, but instead investing in something that could not only provide an income, but be passed to their children.

Mr and Mrs Horgan's current estate is smaller than the inheritance tax nil-rate band for one person (pounds 231,000 this tax year).

Even when the Teachers' Assurance policy matures and the tax-free cash of pounds 100,000 is paid at retirement, the estate will easily be covered by the couple's nil-rate bands.

Assuming they did not both die at the same time, the problem would occur after the first death. The survivor would suddenly have an estate considerably bigger than the nil-rate band and an inheritance tax bill would have to be paid by the beneficiaries on the second death. But until both have retired and the tax-free cash has been received very little can be done in the way of inheritance tax planning right now.