Shirley and David, in their early 50s, have recently taken early retirement from successful City careers. They have built up a considerable portfolio of pension and non-pension assets and live in a valuable house in the South-east. They have a target income of £50,000 net a year and are also quite anxious about the fact that, were they both to die now, there would be an inheritance tax bill of nearly £1m. How should they proceed for optimum income while mitigating IHT liabilities?
This is a situation that requires some fairly fundamental financial planning. The priority is to provide sustainable income for what may be 30 or more years of retirement. The pensions will probably have to be brought into play sooner than would be ideal as there are guaranteed annuity rates available on some of the with-profits funds. But there is some concern about calling on unit-linked funds when they are at relatively low values.
Using a deferred annuity vehicle will have a number of advantages, not the least of which is that many of the unit-linked investments can be brought into play without having to convert them to annuities at this stage. In this way, a modest stream of sustainable income can be derived from some of the funds, holding some of them in reserve for the future, using tax-free cash to augment the income in the early years. Not quite phased drawdown but nearly.
It will also be important to ensure that they are both able to protect and improve their state benefits by calling for a projection from the Pension Service. If appropriate, Class 3 voluntary contributions can be made to maximise future benefits. It is often held that the state pension does not amount to much but Shirley and David could find themselves with the best part of £8,000 a year index-linked in a decade, along with any additional benefits. They would need £200,000 or more in capital assets to generate this kind of income and this will help with the inheritance tax in the future for relatively little cost now.
One problem they have is the fact that quite a portion of their investment was put some time ago into zero-dividend preference shares. This is a portion of their portfolio that needs care and probably time before it can be relied on for any serious income generation. We propose to keep this portion of money to one side for the time being, which puts a bit more pressure on the rest of the portfolio.
On the other hand, they have built up a decent portfolio of fixed-interest investments within their Peps and Isas over the years and it is time to bring these into play. Drawing the best part of £10,000 as tax-free income makes a considerable dent in their target and the tax advantages greatly add to the efficiency of the vehicles. David was concerned that it might be more efficient to let the income roll up tax-free within the Peps and Isas but, as they are now income investors, drawing the income is vital. This gives the more equity-orientated part of the portfolio time to regenerate after the mauling it has suffered over the last few years.
Ultimately, Shirley and David will be able to provide the level of income needed but it is going to be a tight squeeze. They will be able to avoid being higher-rate taxpayers and, indeed, can keep their overall tax bills down. But there is not much scope for making gifts to mitigate the potential IHT bill.
We have looked at various vehicles, such as the abysmally entitled spousal alienation trust and the IOU route for the home, but they are too young to get overanxious about inheritance tax. Their priority is income and they need to maintain proper control and flexibility over their assets.
They will rewrite their wills to ensure that both nil-rate bands are used on their deaths using specific bequests and discretionary trusts. But, at their age, there is a low-cost alternative to giving away assets. A joint-life, second-death life policy on a maximum cover basis would only cost them about £60 a month or so to shelter £1m and this is a much more practical solution – written in trust, of course. When the policy is reviewed in 10 years, the costs will increase but their circumstances will have changed so other avenues are open to them. This gives protection against the unexpected in the early years of their retirement.
Overall, the gross yield required to provide the income target is about 4 per cent, which should be realistic, giving some concession to the problem with the zeros.
Being able to avoid about £10,000 a year of income tax makes the structure more appealing and they can be reasonably confident that the capital value of the portfolio and its income will be protected against inflation for the long term, giving scope for growth.