‘I want to pass on a £2.7mn pension – how do I cut my tax bill?’

Tim is 61 and works part-time in two non-executive director roles for which he earns £35,000 a year. He and his wife also get around £65,000 a year from dividend income. They have one child.

Tim and his wife’s home is worth around £1.6mn and they own a house abroad worth about €900,000 (£802,143). Both properties are mortgage-free.

“I want to be able to live comfortably in retirement, fund any care costs for myself and my wife in later life, and buy a property for and pass assets tax-efficiently to our child,” says Tim. “I plan to transfer as many investments as possible into tax-efficient wrappers and sell the remainder over time. I have two self-invested personal pensions (Sipps) from which I have not yet drawn as I am delaying drawing from pensions for as long as possible because they fall outside of my estate for inheritance tax (IHT) purposes. I have fixed protection of £1.8mn for the pensions, but their value – about £2.9mn – still exceeds this.

“I would like our investments to make an average annual total return of 8 to 10 per cent. I would say that I have a moderate to high investment risk appetite. I have been investing via company saving schemes and pension plans for 25 years and have a long-term investment mindset, as we probably have sufficient assets to last for the rest of my wife’s and my own lives. In recent years, high volatility has caused the value of our portfolio to move by up to 20 per cent a year – both up and down. Although I am uncomfortable with this, I am prepared to ride out these down periods and see them as an opportunity to top up holdings. Last year, for example, I topped up Rio Tinto (RIO) and Anglo American (AAL) as both had performed well and I thought that they had further to go.

“I tend to buy and hold investments unless the reasons why I originally bought them change. I review the portfolio once a quarter and make decisions at those times rather than on the basis of day-to-day price movements. For example, last year I sold all of our holdings in waste management company Biffa because I was disappointed that a takeover bid for the company was going through. I liked that industry sector, and the company’s market position and prospects, and would have been happy to remain a shareholder.

“We used to have a more broadly diversified portfolio with 10 per cent in cash, 30 per cent in fixed income and 60 per cent in equities. But I offloaded the fixed-income investments a couple of years ago as their risk/reward ratio had become increasingly unattractive.

“Roughly half of the equity portion of the portfolio is in large companies, a quarter in mid-caps and the rest in smaller companies. Smaller companies have been out of favour for some time so I think that they offer opportunities to invest in interesting companies with solid growth prospects at significant discounts to their fair values. I believe that this is a good time to invest as attention and appetite lie elsewhere. So I am thinking of adding to some of our smaller company holdings, such as Mpac (MPAC), Trinity Exploration & Production (TRIN) and Parkmead (PMG).”

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

Eilidh Anderson, investment manager at Kingswood (KWG), says:

Over your 25 years of saving and investing, you have made good decisions that have set you up well for retirement. You are debt-free, semi-retired and have 60 per cent of your investable assets in tax-efficient wrappers. You have clear investment objectives, a long-term investment horizon and are taking a sensible buy-and-hold approach with quarterly reviews.

But although you describe your attitude to risk as moderate to high, your overall exposure is high-risk with 95.7 per cent of your investments in equities, 67.5 per cent of which are direct equity holdings. This is particularly the case with smaller companies, which are more volatile.

It's normal to reduce your risk as you enter retirement and require access to the investments or income. You could manage the accounts you expect to draw from first with a lower risk profile to give you more certainty of cash flows. But you could run your Sipp, which is outside your estate for IHT purposes, with a higher risk profile due to its longer-term horizon.

Consider your investments’ concentration risk – the amount of exposure to one company, sector or country. Around 20 per cent of your investable assets are in JPMorgan Chase (US:JPM), which is a large portion of your wealth to tie to the fate of one company. You may know the company well or consider it a cherished holding but, for example, its share price fell 34 per cent during the sell-off between February and April 2020. You have a further 21.3 per cent of your investments in five funds [and Mercantile Investment Trust (MRC)] run by JPMorgan Asset Management. Although the funds are diversified, it still increases your exposure to the asset manager. We construct portfolios with no more than three funds per asset manager, with a maximum 10 per cent weighting per fund and maximum 20 per cent exposure to an asset manager. 

Consider reducing your position sizes where you can within your annual capital gains tax (CGT) allowances. However, as CGT is lower than income tax and IHT, if your wife is a basic rate taxpayer, you could gift shares into her name to fully use her rate and allowances. Another option is to hold most of your dividend-paying investments within Isas via an annual ‘bed and Isa’. This would enable you to maximise your Isa efficiency, as any Isa income is tax-free. Also, under flexible Isa rules, withdrawals can be added back in the tax year they were made without impacting your annual Isa allowance.

Given your desire for smaller company exposure, part of your Isa could be invested in Aim shares, which would shelter some of your estate from IHT after you had held them for two years.

You have picked some good companies and funds, but would benefit from some strategic asset allocation. The risk/reward ratio of fixed income has changed – you can now get a 4 per cent yield on a bond, which would reduce your portfolio's risk and increase your overall diversification. Adding some alternative assets exposure through funds that invest in infrastructure, structured products or gold would reduce your correlation to equities too.

You are overweight the UK at the expense of other regions, such as Europe, Asia and emerging markets. And consider investing in diverse thematic funds that focus on relevant issues such as energy transition and healthcare.

The dividend tax and CGT allowances are set to fall drastically over the next two tax years, which will impact around 40 per cent of your investable assets as they are in taxable accounts.

You want an average annual total return of 8 to 10 per cent, but financial planning could provide added savings. Holding the most efficient products [for your financial requirements helps, for example], offshore bonds and trusts can be beneficial for investors who have used up their pension and tax allowances and help to protect their estates from IHT.

A formal review of your Sipps and their charges could also be beneficial as high costs impact your ability to generate compounded returns over time, as could setting up a Sipp for your wife.

Rebecca Lucas, chartered financial planner at Becketts, says:

You have managed your investments well and built up a good level of wealth. But this means potentially incurring IHT and the pensions lifetime allowance charge. But you can take some steps now to improve your position.

Do you spend all your income or have a surplus? To mitigate your IHT liability, you could use an exemption called 'regular gifts out of income'. As long as you meet certain criteria set by HM Revenue & Customs (HMRC), you could gift some of your surplus income to your child on a regular basis. But ensure that these gifts are from income and making them does not impact your standard of living.

A lump sum gift to your child would fall outside of your estate for IHT purposes if you survive for seven years after making it. So act sooner rather than later if you want to make gifts. You could make a gift outright to your child or, if you want more control, get professional advice and set up a trust with your child as a beneficiary. Keep records of any gifts you make because they will need to be reported to HMRC on your death.  

As well as Isas, consider investing some of your money in other tax-efficient wrappers. Aim share portfolios have high growth potential and are potentially IHT-free after you have held them for two years. Some providers enable you to hold them within Isas.

Enterprise Investment Schemes also have high growth potential, are IHT-free after you have held them for two years, offer 30 per cent income tax relief and are CGT-free. Venture capital trusts have high growth potential, too, offer 30 per cent income tax relief and tax-free dividends, and are CGT-free.

You have sufficient income and assets, so you haven't needed to touch your pension. It will be assessed against the lifetime allowance when you take benefits and at age 75, even if you have not accessed the fund. You have an enhanced lifetime allowance of £1.8mn but the size of your pension is about £1.1mn greater than this at present. The more your pension grows between now and when you are age 75, the greater your tax bill will be. If you leave your pension untouched, at age 75 you will incur tax of 25 per cent on the excess above £1.8mn. There isn’t much you can do to minimise this large tax charge, but your pension is outside your estate for IHT purposes.  

As you tend to buy and hold shares, your investments outside pensions and Isas may have unrealised capital gains. The CGT annual allowance will fall from £12,300 to £6,000 a year on 6 April and then down to £3,000 from April 2024, so fully use your CGT allowances this year. It’s great that a large chunk of your investments are in Isas – keep using the full annual Isa allowance each year.

Keep an eye on the interest you are getting on your £50,000 cash savings account. Shop around for a better rate, if necessary, because some banks have been slow to respond to the Bank of England's rate increases.