Investing for a future objective (e.g. retirement) is a great starting point but we need to dig a little deeper to understand the specific reason for ‘why’ the investment is being considered.
For example, rather than investing for ‘retirement’, a more specific objective is ‘to achieve an income in retirement of £40,000 p.a. from age 60 for the rest of my life’.
By being specific when setting goals, we as advisers, are able to analyse your current financial position and create a cashflow model which will calculate the level of investment return that you will personally require year by year in order to meet your specified objective.
This required rate of investment return can then be reviewed to ensure the specified objective is, firstly, realistic (i.e. that funds will not be exhausted early) and secondly, that the required rate of investment return is compatible with your current portfolio asset allocation and hence investment risk profile. Many people often focus solely on their perceived investment risk profile as opposed to understanding how much risk they ‘should’ be taking in order to meet their objective (the two may not necessarily be the same).
By creating a tailored financial plan and consequently a portfolio in this way, most clients will be able to see a clear and direct path from their current position to achieving their short/medium and long term financial objectives.
Of course, there will be variables along the way so it is imperative that the financial plan (cash flow model) is reviewed regularly and updated accordingly.
Although retirement planning is an obvious example, the use of cashflow modelling is equally important when considering all financial/investment decisions, including:
1. Inheritance Tax (IHT) planning
Wanting to mitigate future IHT (possibly by gifting assets now) whilst retaining sufficient assets to cover potential future income/capital needs (e.g. future care fees).
2. School / University fees planning (for either parents or grandparents)
How much to invest now and in what tax wrapper?
Once we know how much risk should be taken within the portfolio, we then need to structure the portfolio within the most tax efficient wrappers (typically for income purposes as discussed here but equally for capital growth, IHT or school fees planning).
Depending on the value of your asset base, the use of your income tax personal allowance, dividend allowance, savings allowance, capital gains tax allowance and your tax free pension commencement lump sum may all play some part in providing the required income.
For example, if we were able to fully utilise the allowances mentioned above, an income of £70,000 can be generated without any tax being paid (this also assumes no income or withdrawals are taken from ISAs). In order to replicate this income in a ‘taxed’ environment, you would need to earn close to £100,000 which will then be taxed at an effective rate of nearly 29% leaving you with a net amount of £71,000.
Remember, the less tax that you have to pay on the money you take, the less you will have to withdraw from your overall asset base. This means that the funds will last longer and more will ultimately be available to your beneficiaries.
The final and important point to note is that the more specific the plan and the earlier you start to plan, the more effective (and tax efficient) the plan can be.
Please note that tax treatment depends on your individual circumstances and some courses of action may not be applicable for all individuals.