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What is the best way to cover the cost of my new house

Our reader wonders if he should withdraw cash from tax-free vehicles or elsewhere
March 12, 2020, Patrick Connolly and Kay Ingram

Earl is 66 and retired. He receives pension income of around £11,000 a year, and £20,000 in interest and dividends from investments outside tax-efficient wrappers. His home is worth about £560,000 and mortgage-free.

Reader Portfolio
Earl 66
Description

Sipp, Isa and general investment account invested in funds and shares, unquoted company, cash, residential property

Objectives

Annual income of £38,275, buy a new home worth £1m, leave assets to godchildren

Portfolio type
Managing pension drawdown

“I have budgeted to spend £38,275 in 2020," says Earl. "And over the past decade, on top of my annual expenditure, I have spent £252,749 on costs such as new cars and home maintenance.

"I have investments worth around £3.7m, split between a self-invested personal pension (Sipp), individual savings account (Isa) and general investment accounts. I think that I could make an annual withdrawal from them of between £55,000 and £74,000 – 1.5 per cent to 2 per cent of my investments. I would take this via dividends and by selling assets when the market is high. With my pensions, this would give me a gross annual income of between £70,000 and £90,000.

"I thought of buying an annuity for security of income. But this reduces my options and the value of my godchildren’s inheritance, and I don't think I need this security. I am resigned to my beneficiaries paying whatever inheritance tax (IHT) they have to. But I will probably increase the cash gifts I make to them – at present I give £5,000 a year.

"I would like to spend around £1m on a new house. Taking this sum from my investments would reduce the income I get from them, but I would still more than meet my budgeted expenditure. I am thinking of taking my pension 25 per cent tax-free entitlement, but am not sure whether to cover the rest by drawing from my Isa, or selling investments outside tax-efficient wrappers and incurring capital gains tax (CGT). 

"I am likely to breach my pensions lifetime allowance of £1.5m. I intend to use the money in my pension to fund care in later life, if necessary, although I could also do this by selling my home. 

"I also wondered to whom I should entrust management of my financial affairs if I can’t do this when I'm older?

"And should I partially or fully transfer my investments to another broker? Most of my investments are with one firm.

"I have been investing since 1980 and accept that markets can crash. I could tolerate a fall in the value of my investments of up to 75 per cent in any one year because I have a cash balance that, with my pensions, would cover more than 10 years of my current budgeted expenditure. 

"I don’t think bonds offer much value, but have a small allocation to government bonds as a higher-interest alternative to cash. I also prefer growth investments to income-paying ones, to keep me in the basic-rate tax band. 

"I plan to reduce my allocation to direct shareholdings gradually and reinvest the proceeds in investment trusts. I choose these on the basis of cost and performance, and will not buy them if they are trading at a premium to net asset value (NAV).

"My equity allocation is biased towards the UK to get earnings and growth in the currency I mainly spend in. But if the UK market outperforms in the short term and the exchange rate becomes favourable before the next election, I will reduce my UK exposure.

"I have lost out by being underweight North America, but will not add funds focused on this region unless the exchange rate is at least $1.80 to the pound. And my global equities funds give me exposure to this market. However, I am reducing the Fundsmith Equity (GB00B4M93C53) holding within my Sipp because it accounts for 5 per cent of my overall investments and I am concerned about this fund’s size.

 

Earl's portfolio

HoldingValue (£)% of the portfolio
BlackRock Smaller Companies Trust (BRSC)68880.001.68
BlackRock World Mining Trust (BRWM)16240.950.4
Caledonia Investments (CLDN) 567001.38
Fidelity China Special Situations (FCSS)398650.97
Fidelity Special Values (FSV)  46035.001.12
Finsbury Growth & Income Trust (FGT) 632801.55
ICG Enterprise Trust (ICGT)600001.47
India Capital Growth Fund (IGC)35200.000.86
Scottish Mortgage Investment Trust (SMT)63819.501.56
TR European Growth Trust (TRG)28890.000.71
Witan Investment Trust (WTAN)58125.001.42
ASI UK Smaller Companies (GB00BYQNBS53)59475.571.45
Fundsmith Equity (GB00B4M93C53)205542.385.02
JOHCM UK Equity Income (GB00B03KR617)57802.421.41
Liontrust Special Situations (GB00B0N6YF70)74874.531.83
Merian UK Smaller Companies (GB00B1XG9599) 43453.911.06
MI Chelverton UK Equity Income (GB00B1FD6467)50676.031.24
C&J Clark 31350.000.77
Costain (COST) 7929.600.19
Diageo (DGE)  31910.000.78
Grainger (GRI) 72589.381.77
M&C Saatchi (SAA )7260.000.18
Vertu Motors (VTU) 16852.000.41
Alliance Pharma (APH)63375.001.55
Dechra Pharmaceuticals (DPH)129477.123.16
Halma (HLMA)107250.002.62
ITV (ITV)37637.50.92
Manolete Partners (MANO) 220000.54
Baillie Gifford Japan Trust (BGFD)375300.92
Baillie Gifford Shin Nippon (BGS) 81450.001.99
Fidelity European Values (FEV) 74100.001.81
JPMorgan Japanese Investment Trust (JFJ)  70729.491.73
JPMorgan Japan Smaller Companies Trust (JPS)61320.001.5
BlackRock Throgmorton Trust (THRG)72240.001.76
VinaCapital Vietnam Opportunity Fund (VOF) 53840.001.31
AXA Framlington Biotech (GB00B784NS11)76572.371.87
Barings Europe Select (GB0000796242)52669.881.29
BlackRock Gold and General (GB00B99BDY18)26612.290.65
Hermes Global Emerging Markets (IE00B3DJ5K90)59780.681.46
JPM Natural Resources (GB00B88MP089)17360.170.42
Marlborough Special Situations (GB00B907GH23) 61271.131.5
Melchior Asian Opportunities (LU1205354803)38851.100.95
Slater Growth (GB00B0706C66)61788.001.51
Artemis US Smaller Companies (GB00BMMV5766)100269.862.45
First State Greater China Growth (GB0033874107)74976.061.83
Jupiter European (GB00B4NVSH01)51664.541.26
Legg Mason Japan Equity (GB00B8JYLC77)78502.211.92
LF Blue Whale Growth (GB00BD6PG563)114730.552.8
Liontrust UK Micro Cap (GB00BDFYHP14) 21706.920.53
Merian North American Equity (GB00B1XG7P54)90271.702.2
Merian UK Mid Cap (GB00B1XG9482)77142.801.88
Schroder Asian Alpha Plus (GB00BDD27J12)86649.782.12
Slater Recovery (GB0031554248)63058.921.54
Stewart Investors Indian Subcontinent Sustainability (GB00B1FXTG93) 82628.952.02
TB Amati UK Smaller Companies (GB00B2NG4R39) 105100.882.57
TB Evenlode Income (GB00BD0B7C49)91930.352.24
TB Evenlode Global Income (GB00BF1QMV61)49418.371.21
Threadneedle European Smaller Companies (GB0001531531)112875.482.76
Veritas Asian (IE00B02T6J57)62371.911.52
Fidelity Japan Trust (FJV) 690301.69
Geiger Counter (GCL)151050.37
Cash345260.208.43
Total4095300.48 

 

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

 

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

The general view used to be that over time you could take 4 per cent of your wealth from income or capital gains, and leave the capital intact after inflation. But now negative prospective real returns on cash and bonds mean that you need a massive allocation to equities to achieve real returns of 4 per cent a year. And even then it is by no means assured. Slower than expected long-term global growth could depress longer-term returns.

But the difference between taking 4 per cent and what you are actually spending this year is so huge that returns would have to fall very far short of 4 per cent a year for you to eat much into your capital.

You could raise money to buy a bigger house by taking the 25 per cent tax-free allowance from your Sipp.

Otherwise, it’s usually better to leave as much as possible within tax-efficient wrappers and draw on assets outside them. This can incur a CGT liability. But don’t let tax considerations distort your decisions.

Annuities avoid investment risks, but your annual spending is small. Also, annuity rates are very low, so I would defer buying one until rates improve.

 

Patrick Connolly, chartered financial planner at Chase de Vere, says:

You draw on a very small percentage of your assets each year, so could increase your income if you want to – especially as you have cash reserves that would help to cover 10 years-plus of your current expenditure. Only drawing income of between 1.5 per cent and 2 per cent a year from your investments and having a sensible investment strategy could mean that your investments deliver some capital growth over the longer term.

And because you're not taking the £15,000 a year income your Isa investments are generating, you could significantly increase the amount of income you take without a higher tax bill.

Buying an annuity would give you a guaranteed income for the rest of your life. The rate you get depends on your circumstances and health. For example, if you are in good health, you might get 2.9 per cent a year. But you have considerable scope to increase your income from your existing assets and annuity income is taxable. Also consider what size of inheritance you wish to pass on when deciding whether to buy an annuity.

You are thinking of withdrawing £1m from your investments to buy a new home. If you draw this from holdings outside tax-efficient wrappers you might incur a considerable CGT bill. If you draw from your Isa this will reduce the scope for tax-free income. And if you take money from your Sipp this will use part or all of your tax-free cash entitlement, and incur additional tax on any amounts above this. 

The best approach is probably a combination of these options, but an in-depth analysis will be required to determine exactly what the best approach is for you, considering issues such as your likely future income requirements.

If it doesn’t affect your options, you might as well make gifts to your godchildren that aren’t subject to IHT rather than gifts that potentially could be. You're already gifting more than the £3,000 annual exemption. But gifts made on a regular basis can be exempt from IHT regardless of their size. To qualify, the gifts must come from your normal expenditure and be made out of income, and you must still have sufficient income to maintain your usual standard of living.

Any pensions lifetime allowance tax charge will only be applied on the amount that exceeds your lifetime allowance when a benefit crystallisation event occurs, such as taking benefits or reaching age 75. 

Consider crystallising the pension before its value reaches £1.5m and taking your 25 per cent tax-free entitlement. This would mean that you don’t incur an immediate charge. But this would involve taking out around £355,462 from your pension, which is also likely to be subject to tax on income and/or capital gains, depending on how you save or invest it. It would also incur IHT when you die.

Even if you crystallise the pension it will still be tested against the lifetime allowance at age 75, when the money designated for drawdown is deducted from the fund value to determine the crystallised amount. But you can take income from the pension to maintain its value at its current level so will not have any further growth at age 75 for lifetime allowance purposes. Any income you withdraw will be subject to income tax at your marginal rate.

If you die before age 75 there will be no further test of a crystallised pension fund against the lifetime allowance. However, if this pension hasn’t been crystallised then it will be tested and potentially suffer a tax charge. This is a complex area so you should get independent financial advice on this.

Your platform, Hargreaves Lansdown, is very unlikely to go bust. And all its client money is ring-fenced from the business, so it cannot be used to cover its obligations or be claimed by any creditors. 

Taking out Lasting Power of Attorney through a solicitor is the best way to entrust management of your financial affairs to someone in the event that you are unable to. These allow other people to make decisions about your finances, or your health and welfare if you lose mental capacity. You can set out instructions on what you want to happen. Many people nominate a family member or close friend as their attorney. Otherwise appoint a professional attorney, such as a solicitor. Although they don't have a personal relationship with you their focus is on what’s best for you and, although you have to pay for their services, they might act more objectively.

 

Kay Ingram, chartered financial planner at LEBC Group, says:

When planning retirement income, distinguish between essential and discretionary spending, and provide for the two in different ways. Essential spending should come from guaranteed income, especially as you get older. A regulated adviser specialising in later life planning would also be able to advise on care fees provision, if necessary.

Although the value of your investments gives some scope for significant losses, you are relying primarily on growth for your future income. After 10 years of a bull market and significant challenges to growth, this may not be wise.

Reorientating your Isa investments to produce more income would enable you to meet your annual income shortfall tax efficiently. You should be able to generate an annual yield of 2.5 per cent and achieve growth in line with inflation. The dividends from investments within the Isa are tax-free. This would more than meet the shortfall in your income and, while dividend income is not guaranteed, it would be a lower-risk way to get income than relying almost entirely on growth. 

You could use your cash reserves to cover one-off costs or other discretionary spending when markets are falling.

You should sell your taxable investments to meet the bulk of the funds required for your house purchase. The net proceeds will depend on the amount of capital gains payable. By stripping out gains and losses each year, within the £12,000 CGT allowance, you minimise the tax payable. Your taxable income is about £30,000 this year, so you will pay tax of 10 per cent on the first £20,000 taxable gains and 20 per cent on any above that.

If the net amount realised is not enough you could make a withdrawal from your pension. This is subject to income tax on up to 75 per cent of the withdrawal, with 25 per cent tax-free up to £375,000. Doing this could be more tax efficient than taking all the tax-free sum up front and should mean that you remain within the basic rate for income tax.

When more than the protected amount of your pension has been withdrawn a one-off tax charge applies to any excess. This is at 25 per cent of the excess if taken as income, which is also subject to income tax, or 55 per cent if taken as a lump sum. After age 75, no further lifetime allowance charges apply and the remaining fund can be left to grow tax-free. You can take ongoing income or make one-off withdrawals.

Any Sipp funds left after you die can be left to nominated beneficiaries and fall outside of your estate for IHT purposes. An inherited pension fund also does not count towards the recipient’s lifetime allowance. 

You may wish to consider taking regulated financial advice as a lot of your income will be dependent on investment returns. A regulated adviser can help you select an appropriate investment strategy to make your income sustainable and provide ongoing reviews as circumstances change.  

Without a lasting power of attorney, if you lose mental capacity your assets are frozen and no one else can act on your behalf without the agreement of the Court of Protection – a process that can cost considerably more than appointing a power of attorney.

 

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

You believe that a sterling-based consumer like yourself should hold sterling assets to reduce currency risk. But sterling is a risky asset and often falls when stock markets do really badly, for example in late 2008 or February this year. So assets denominated in foreign currencies can act as a shock absorber.

A bigger issue in deciding how to split your equity holdings' geographic allocation is whether the UK is undervalued relative to overseas. If this is the case, it would be a better justification for having a substantial allocation to the home market.

Your holdings in smaller companies and mining funds expose you to cyclical risk. This might pay off when the world economy shakes off the threat of the coronavirus, but they are risky positions.

I suspect that some of your good returns, for example from funds such as Fundsmith Equity, Finsbury Growth & Income Trust (FGT) and Scottish Mortgage Investment Trust (SMT), are because investors used to underprice stocks with monopoly power but have corrected this error in recent years. However, this process might have gone too far now. High past returns are a reason for caution because they warn that the assets that generated them might now be overpriced.

You seem underweight private equity assets and unquoted stocks. But I suspect that over the long run unquoted assets might return stronger growth than companies quoted on public markets.

 

Patrick Connolly says:

You are right to try to reduce your number of holdings and sell your direct shareholdings. You should fully use your annual Isa allowance to ensure that as many of your assets as possible are in tax-efficient wrappers. You could do this by selling direct shareholdings outside tax-efficient wrappers that haven't made significant capital gains, and reinvesting the proceeds within an Isa.

You could start to take profits on Dechra Pharmaceuticals (DPH) and Halma (HLMA), which have done well, and reinvest the profits.

You plan to reinvest the proceeds from sales of direct shareholdings in investment trusts. Over the long term, investment trusts often outperform open-ended funds. But they can be riskier and more volatile because they can gear – take on debt – and move from a discount to a premium to NAV and vice versa. So they could make bigger short-term falls if markets perform badly.

Also, many investment trusts rarely move to a premium so if, for example, you buy a trust at a discount of 2 per cent and it then moves to a discount of 10 per cent before you sell, you will still have lost out.

And there are far fewer investment trusts to choose from than open-ended funds. So first consider what are the most suitable investments for you to reinvest in, and then which fund structure is the best way to access them.

Many investors have large core holdings giving broad exposure to asset classes or markets, alongside smaller allocations to investments that provide exposure to specific specialist areas. You already have some excellent core holdings, such as Witan Investment Trust (WTAN), Scottish Mortgage Investment Trust, Fundsmith Equity and TB Evenlode Income (GB00BD0B7C49). You could also use passive funds to get low-cost exposure to different markets.

You have a large number of investments focused on specialist areas, such as Japan, India, smaller companies, natural resources and biotechnology. This is fine, as long as you are aware of and happy with their greater risks. Follow a coherent investment strategy rather than look for individual opportunities.

Many fixed-interest assets – bonds – look expensive on a historic basis. However, there continues to be support for bonds, and they can provide a good degree of protection in stock market downturns and a steady level of income. If you hold fixed-interest investments within Isas they will not incur tax. And they would generate a more consistent level of income, which you could draw or reinvest.