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Improve your returns with some tax planning

Our reader needs to undertake some careful planning to ensure he doesn't breach his pensions lifetime allowance
June 15, 2017, Lawrence Cotton & Craig Ray

Tony Hill is 61 and retired. He has a number of sources of income, including a level annuity with Standard Life that pays him £7,400 a year. He also receives dividends of about £4,500 a year from UK shares worth about £110,000 held in a trading account with Barclays, dividends worth around £8,000 a year from a portfolio worth about £165,000 held in an individual savings account (Isa), rental income of £6,600 from a mortgage-free property and interest of about £600 a year from a cash deposit of £60,000.

Reader Portfolio
Tony Hill 61
Description

Sipp, Isa & trading account

Objectives

Income of £45,000 a year

Portfolio type
Managing tax

His stakeholder pension, which was bought in September 2012, was valued at £215,141.19 and used up 14.33 per cent of the standard lifetime allowance.

"My desired income in retirement would be £45,000 a year, to achieve a disposable income of £20,000 together with fixed expenses of £25,000," says Tony. "I intend to convert my self-invested personal pension (Sipp) to uncrystallised flexible access sometime next year. But I am not sure whether the equity allocation in it is too high or too low, and how the rest of my asset allocation could be improved to reflect my circumstances.

"I am not contributing to my Sipp, but I'm slightly concerned that, together with my annuity, my pension assets are approaching £1.2m. I have secured a lifetime allowance of £1.25m, but I retain dividends within the Sipp and without reductions in the Sipp valuation it may eventually exceed that amount.

"I am comfortable with my Sipp holdings. Volatility has been low, especially on downward trends for equities, while upswings seem to lift non-equity positions, too. I look to avoid risk in my Sipp portfolio and think that equities are too near the top of an upwards cycle. But I have never really understood bonds so, although I may have missed out over the years, I am not willing to invest in this asset class now.

"I am happy with my allocation to infrastructure-related assets as the Sipp portfolio's 3 per cent yield is boosted by them.

"Recent trades include the sale of McCarthy & Stone (MCS) and Greene King (GNK) following poorly received updates.

"I have added SSE (SSE) and BB Healthcare Trust (BBH), and reduced my cash allocation to add to GlaxoSmithKline (GSK), Saga (SAGA) and National Grid (NG.)

"My holding in BH Macro (BHMU), a listed hedge fund, has been tendered for repurchase by the company. If the reorganisation goes ahead the shares will be redeemed at close to net asset value. I am not entirely convinced that I should reinvest any cash proceeds.

"Last year I reduced by 20 per cent holdings that seemed to have done better than the general equity market. These were CRH (CRH), GlaxoSmithKline (GSK), John Laing (JLG) and Saga (SAGA). And I introduced a position in Bluefield Solar Income Fund (BSIF)."

 

Tony's Sipp portfolio

 

HoldingValue (£)% of portfolio
CRH (CRH)33,648.003.3
RIT Capital Partners (RCP)75,400.007.4
SSE (SSE)35,712.003.51
GlaxoSmithKline (GSK)50,355.004.94
Trojan Fund (GB0034243732)35,034.763.44
Royal Dutch Shell (RDSB)66,840.006.56
National Grid (NG.)40,520.003.98
Third Point Offshore (TPOU)41,342.354.06
Qatar Investment Fund (QIF)42,200.004.14
First State Global Listed Infrastructure (GB00B24HJL45)42,205.214.14
John Laing Infrastructure Fund (JLIF) 33,375.003.28
Diverse Income Trust (DIVI)30,080.002.95
Polar Capital Global Healthcare Growth and Income Trust (PCGH)37,624.383.69
Standard Life Investments Global Equity Unconstrained (GB00B6915J97)35,451.683.48
Source LGIM Commodity Composite UCITS ETF (GBP) | LGCF49,725.004.88
Standard Life Global Absolute Return Strategies (GB00B7K3T226)36,170.683.55
Bluefield Solar Income Fund (BSIF)44,400.004.36
UBM (UBM)33,750.003.31
Saga (SAGA)40,860.004.01
Spire Healthcare (SPI)32,680.003.21
John Laing (JLG)34,524.003.39
3i Infrastructure (3IN)32,714.403.21
BB Healthcare Trust (BBH)36,640.003.6
Cash77,200.007.58
Total1,018,452.46 

 

 

 

NONE OF THE COMMENTARY BELOW SHOULD BE REGARDED AS ADVICE. IT IS GENERAL INFORMATION BASED ON A SNAPSHOT OF THESE READERS' CIRCUMSTANCES.

 

 

THE BIG PICTURE

James Baxter, managing partner at Tideway Wealth, says:

I would start with the tax and wrapper planning before looking at specific investments, as getting your tax planning right at the outset is a zero-risk way of improving your net-of-tax return.

Cashing in your Standard Life pension in 2012 used up 14.33 per cent of the then lifetime allowance. With 85.67 per cent of your fixed protection limit of £1.25m left you have £1,071,000 before breaching the limit, which you are fast approaching.

As soon as your account exceeds £1,071,000 apply for your 25 per cent tax-free cash sum of £268,000 as this will effectively be frozen out at this level by the lifetime allowance limit, irrespective of future fund growth. The remaining £800,000 can then go into a flexible drawdown account.

If you invest the tax-free sum in the same equity investments as in your Sipp you can offset these against the nil-rate dividend allowance of £5,000 a year and a nil-rate capital gains allowance of £11,300 a year. On capital gains over the allowance you pay tax of 10 per cent or 20 per cent as a basic- and higher-rate taxpayer, respectively. On dividends over the £5,000 allowance you pay tax of 7.5 per cent, or 32.5 per cent.

But each year you can add to your Isa, for which the annual allowance is currently £20,000.

If you keep these investments in an unencashed Sipp and theytake the fund value beyond £1,071,000 you will be liable to 55 per cent tax if you withdraw further profits as cash, irrespective of whether it's from dividends or gains. Or if you convert them to a drawdown fund you will be liable to 25 per cent tax, which is then still liable to marginal income tax rates on further withdrawals.

Then consider how you will generate your income target of £45,000 a year tax-efficiently.

If you invest your Isa in higher-yielding fixed-income funds, of which there are several yielding around 5 per cent gross, you could generate around £8,000 tax-free. Plus, you can receive annuity income and rental income of up to £11,500 tax-free.

This leaves you looking for another £25,000 of after-tax income. One solution would be to build a portfolio in the Sipp drawdown account which generates around 3 per cent natural yield on £800,000, say £24,000 a year, which could be withdrawn at basic-rate tax giving you another £19,200 a year. Then you could add the tax-free cash to your current share portfolio in a general investment account and target a dividend yield of around 3 per cent. Even after the higher-rate tax on the dividends you would be comfortably over your target income net of tax.

This can be achieved without having to regularly cash in any capital element of your overall portfolio. Given you could comfortably live off your investments' natural yield after tax, it takes the pressure off whether you buy bonds or equities, as your holding period for all your investments can be long term.

In general, you need to avoid big capital losses and not over-reach for returns as you are effectively investing irreplaceable capital. I would suggest holding bonds in the Isa, equities in the general investment account and a mix in the drawdown account to get the overall balance right. And have a general 3 per cent a year yield target after fees in the general investment account and Sipp, and 5 per cent a year yield target in the Isa.

 

Lawrence Cotton, investment manager at WH Ireland, says:

The assets you have set out are in excess of the nil-rate band, so when you factor in your main residence there is likely to be a substantial inheritance tax (IHT) liability on your estate.

You have an income shortfall of £18,400, reducing to £12,000 when the state pension becomes payable. To make up the shortfall you should initially consider using your capital gains tax allowance annually to draw capital from the general trading account portfolio to supplement income. This will result in no further income tax being payable and will decrease the estate size, reducing the IHT liability.

If you hold bond or gilt investments within the taxable portfolio and your current level of income remained, you could benefit from the £1,000 a year savings allowance. Reducing the taxable portfolio would reduce the dividends payable, which would be beneficial if the tax-free dividend allowance is reduced to £2,000.

If you crystallise pension benefits to avoid a lifetime allowance excess charge, taking capital into your estate, this could result in a higher IHT liability so this should be kept under review.

Extinguishing the taxable portfolio, Isa and non-emergency cash reserves first, and then drawing the pension tax-free cash annually could mean minimal tax is paid throughout retirement and your heirs' IHT liability is reduced.

 

Craig Ray, investment manager at Wilson King Investment Management, says:

You have already claimed the lifetime allowance, are aware that you are approaching the limit and intend to convert your Sipp into an uncrystallised flexible access scheme. There are a number of considerations with this, so you will need to speak to a financial adviser to make sure you are fully aware of the advantages and negatives of the plan, as well as its suitability in terms of best meeting your requirements going forward.

When you have reached your decision and possibly withdraw the income from your pension you should be able to meet your long-term target of £45,000 a year.

With regard to the amount of equities you should hold, the usual guideline is that it should be the inverse of your age, and you have met a 40 per cent allocation to equities in your Sipp. You are taking steps to reduce the volatility in the Sipp via recent purchases of large capitalised equities, which move at a reduced rate to the main stock market indices, as well as adding to your infrastructure allocation with the purchase of Bluefield Solar Income. Infrastructure assets are lower volatility and can smooth overall returns, which is appropriate for the multi-asset portfolio that the Sipp is becoming.

 

HOW TO IMPROVE THE PORTFOLIO

Lawrence Cotton says:

I suggest rebalancing your Sipp's UK exposure by reducing some of the larger holdings to further diversify. Top-slicing CRH, GlaxoSmithKline, John Laing and Saga, and selling McCarthy & Stone and Greene King was sensible.

The cash balance will increase further when the BH Macro tender completes, but I would not advocate holding all of this as cash. Rather invest it in global equities to provide additional currency diversification and exposure to growth areas outside the UK. Do this via funds or investment trusts with strong performance records.

BB Healthcare Trust is a sensible addition. And continues to build exposure to long-term thematic ideas, such as a water fund, robotics and automation, and cyber security.

I suggest reducing the overweight position to infrastructure assets. Although it provides stable income and long-term capital growth, investors have flocked to this asset class in place of bonds, pushing the premiums to net asset value on nearly all of these trusts to double-digit levels. I would reduce exposure by around 10 per cent and reinvest in more capital-preservation assets.

 

Craig Ray says:

We have considered the suitability, income requirements, appetite for risk and the component parts of the portfolio, and they are well constructed to meet your overall aims. The income-generating assets are generating a total income of £27,100.

You have a good combination of income-generating assets, and diversification, with equities, a mortgage-free property and cash reserves.

The bedrock of your overall wealth - the Sipp - has a cash allocation of around 7.5 per cent, which may sit slightly at odds with your belief that the equity market is near the top of this cycle. However, given the lack of suitable alternatives and your feelings on bonds, the overall allocation may be more appropriate given the moderate valuations of many holdings, their income generation, and the geographic, asset and sector diversification of a number of the holdings.