State the additional information that a financial adviser would need in order to ensure the Declan and Carmen have an adequate income in retirement
Income and Expenses:
Current monthly expenditure
Income/capital needed
Financial Assets and Plans:
Emergency fund requirements
Plans for use of other assets - income/gifts?
Plans to downsize
Declan’s Pensions:
Spouses pension payable on death?
Indexation level?
Is the scheme covered by PPF? (Pension Protection Fund)
Nomination form completed?
Any other deferred pensions?
Carmen’s Annuity:
Are there any guarantees/annuity protection built into Carmen’s annuity?
Investment and Growth:
What is their investment experience?
Growth rates to be assumed/inflation/projections/performance/charges
Personal and Health-related Factors:
Confirm family history/smoker status
Any debts/liabilities
Any inheritances due
Dependents and Gifts:
Dependency of children/confirm gifts required to grandchildren and children
Deposit Account:
Interest on deposit account
Comment on Declan and Carmen’s current pension income
State Pensions:
State Pensions are guaranteed.
Triple locks apply to the new State Pension, increasing in line with the greater of average weekly earnings, CPI (Consumer Price Index), and 2.5%.
Carmen has a reduced State Pension due to a gap in her National Insurance Contribution (NIC) record.
Declan’s Pension:
Declan’s pension is above the new State Pension amount (£185.15 per week) and includes a protected amount that will increase at CPI.
Declan’s total income is £55,300, making him a higher rate taxpayer.
Declan’s defined benefit (DB) scheme benefits are guaranteed, and the Pension Protection Fund (PPF) would protect 100% of the pension in payment and any spouses pension up to 50% of Declan’s pension.
The rate at which Declan’s DB benefits will increase is unknown, but they are likely to provide a spouses pension on Declan’s death.
Carmen’s Pension:
Carmen’s total income is £8,700, and she has some unused personal allowance.
Carmen’s annuity will not keep pace with inflation and remains at a level amount.
Carmen’s annuity appears not to offer any benefits for Declan on her death.
Explain to Declan and Carmen why their investment funds may not be suitable
Equity Allocation:
For medium risk investors, they are overweight in equities.
Equities provide a good prospect for growth and have the potential to outperform inflation.
Diversification:
There is very little diversification in their investment portfolio. They have no exposure to fixed interest or property.
The absence of index tracker funds reduces costs.
Global and European equity funds offer geographical diversification.
Monitoring and Geographical Diversification:
Individual equity funds require a high level of monitoring.
Over two-thirds of their funds are invested in the UK, indicating too little geographical diversification.
Income Considerations:
Income funds may suit their Attitude to Risk (ATR) and income needs.
Declan could benefit by taking natural income, which avoids pound cost averaging, sequencing risk, and market timing.
Natural income would be variable, but they could top it up from significant other assets or encashments if required.
Dividend Yield and Tax Implications:
The unit trust is producing a dividend yield above their Deposit Account (DA) (£2,000 per year) and is liable to tax.
Explain to Declan and Carmen the investment risks of holding 100% equities in their investment portfolio?
Share dividend volatility/dividends can fluctuate
Non-systematic/specific risk - underperformance of a company within a fund
Market risk/systematic risk - risk that stock market will fall and affect all shares
Regulatory risk/misleading information/market manipulation
Lack of diversification/asset diversification is essential to spread risk
Currency risk global equity funds
They require income from their investment portfolio/market timings/ sequencing risk
Explain to Declan and Carmen how diversification may be used to manage and reduce risk.
Diversification reduces risk by reducing concentration/increasing the number of asset classes
Some asset classes are not strongly correlated - a loss with one asset class might not mean a loss in another
Geographical diversification spreads the risk across a number of different economies currencies national markets
Sector diversification reduces the risk associated with specific areas of the economy or particular firms
Recommend and justify actions Declan and Carmen could take to ensure they have sufficient, sustainable income in retirement.
Rec 1: Carmen to make regular pension contributions of £3,600
Justification: Basic rate tax relief on contributions
Tax free growth
Flexible benefits
IHT free
Pound cost averaging
Carmen has some unused personal allowance (from pension income only) / income from additional pension may be tax free
Rec 2: Carmen to make Class 3 NI contributions if she has gaps in years leading up to retirement
Justification: Will increase her guaranteed/index linked pension/triple lock applies higher of CPI, average earnings and 2.5%
In good health/likely to be value for money
Carmen has some unused personal allowance/income may be tax free
Rec 3: Review fund choices on investment portfolio
Justification: Current funds do not provide asset diversification/do not match ATR
Consider Multi Asset funds
Offer asset allocation expertise/uses wider range of assets/investment strategies
Actively managed/professional management
Rebalances regularly
Increases diversification/reduces volatility within one fund
Can access specialist investments/institutional funds
Potential for positive real return over long term
Can be risk rated to match medium
ATR/income and/or growth needs
Good potential for long term growth
Rec 4: Review tax efficiency of investments
Justification: Aim 3
Rec 5: Ongoing reviews
Justification: Monitor performance asset diversification/change in their needs and objectives and personal circumstances
Explain to Carmen how Class 3 National Insurance contributions work and why it is worth her paying the contributions.
- Nature of Class 3 National Insurance Contributions (NICs):
Class 3 NICs are voluntary contributions.
They are paid when there is an inadequate National Insurance Contribution (NIC) record. - Benefits and Entitlement:
Paying Class 3 NICs allows Carmen to increase her entitlement to the State Pension.
The deadline for making payments for missed years is 31 July 2023, and it can be for any missed years as far back as the 2006/07 tax year.
After the deadline, payments need to be made within 6 years of the tax year in which the shortfall occurred.
Payment can be made even though Carmen has reached State Pension Age (SPA), but only for contribution shortfalls that occurred prior to her SPA. - Payment Details and Qualifying Years:
The weekly rate for Class 3 NICs is £15.85 for the 2022/23 tax year, which is equivalent to an annual amount of £824.20.
Paying this amount will earn Carmen ‘1’ qualifying year, representing 1/35th of the State Pension.
A qualifying year is achieved when an individual had taxable earnings above the lower earnings limit.
The State Pension is index-linked, and the triple lock applies, ensuring increases over time. - Cost Effectiveness and Tax Considerations:
Carmen is in good health, making paying Class 3 NICs likely to be cost-effective.
Carmen has some unused personal allowance, so part or additional pension could be tax-free, considering only her pension income.
Explain to Declan and Carmen the financial situation should one of them die.
- Spouse’s Pension and Annuity:
Carmen is likely to receive a spouse’s pension from Declan’s defined benefit (DB) scheme. The pension received would be taxable at Carmen’s marginal rate.
Carmen’s annuity income would cease upon her death. - State Pensions:
Their individual new State Pensions would cease upon death.
Carmen will receive 50% of Declan’s protected amount as a spouse’s pension. - Transfer of ISAs:
ISAs (Individual Savings Accounts) can be transferred between husband and wife upon death.
Upon death, the ISA becomes a ‘continuing account of a deceased investor.’ No further funds can be added, but income and gains remain tax-free up to the earlier of the estate being administered, the ISA being closed, or 3 years and one day from the date of death.
The surviving spouse inherits a one-off additional allowance called an Additional Permitted Subscription (APS).
The APS is equal to the higher of the value of the ISA on the date of the investor’s death or the value of the ISA when it stops being a continuing ISA.
The survivor can use their ISA allowance in the normal way, in addition to any APS. - Jointly Owned Assets:
Jointly owned assets will automatically transfer to the surviving owner upon the first death.
What factors should an adviser consider when reviewing Carmen and Declan’s financial arrangements at the next annual review?
- Financial Goals and Income Capital:
Level of income capital required.
Plans for future gifts.
Consideration of how the gift for grandchildren was made, including the amount, trust used, and future gifts planned. - Utilisation of Allowances and Tax Considerations:
Use of other allowances such as Individual Savings Accounts (ISAs) and Capital Gains Tax (CGT) allowances. - Changes in Circumstances:
Changes in personal circumstances, including health status and the arrival of further grandchildren.
Changes in external factors such as the economy, political climate, and legislative changes.
Consideration of State Pensions and new financial products. - Fund Performance and Charges:
Reviewing fund valuations and performance.
Evaluating dividend income, yield, and charges associated with the funds. - Asset Allocation and Rebalancing:
Assessing the asset allocation of their investment portfolio.
Considering the need for rebalancing based on the desired risk profile and market conditions. - Attitude to Risk and Capacity for Loss:
Reviewing changes to their Attitude to Risk (ATR).
Assessing any changes to their capacity for loss. - Objectives:
Considering any changes to their financial objectives.
What further information would you require to advise Declan and Carmen on this (gifting to grandchildren) objective?
- University Fees and Affordability:
Expected costs of university fees.
Assumed inflation rate.
Affordability considerations. - Annual Exemptions and Gift History:
Have you used your £3,000 annual exemptions this year and last?
Have you made any gifts in the last 7 years? - Details of Proposed Gift to Grandchildren:
Confirm the amount of the proposed gift.
Future gifts and any expected further grandchildren.
Are you prepared to give up all access to your capital?
Are you prepared to gift to grandchildren over a number of tax years to maximize tax efficiency of encashments?
Timescales for the gifts and the ages of the grandchildren.
Can Junior ISAs (JISAs) be used?
How much control do you wish to have over the gift? Consider ownership and the selection of trustees.
Which investment do you intend to use for the gift? - Priority of the Gifting Objective:
Determine the priority level of this aim compared to other objectives or goals.
Explain to Declan and Carmen the difference between using a bare trust or a discretionary trust for the proposed gifts to their grandchildren.
- Flexibility:
Bare trusts:
Beneficiaries cannot be changed, and there is no scope to add further grandchildren.
Beneficiaries can demand the trust fund at age 18.
Discretionary trust:
Trustees have the discretion to change beneficiaries (discretionary class of beneficiaries).
Grandchildren can be included as a class of beneficiary and automatically added when born.
Trustees have full control over when and to whom income and capital are paid. - Income Tax & CGT Position:
Bare trusts:
The full personal allowance of the grandchildren can be used for Income Tax purposes.
The full CGT exempt amount applies for any capital gains.
Discretionary trust:
Holdover relief is available on gains from UT (Unquoted Trading) assets.
The trust has a standard-rate band of £1,000, with additional tax rates of 45% on income and 39.35% on dividends.
The trust has a CGT exempt amount of half the normal amount, split between the number of trusts set up by the settlor. - IHT (Inheritance Tax) Position:
Bare trusts:
PET (Potentially Exempt Transfer)/IHT free after 7 years.
No CLT (Chargeable Lifetime Transfer).
The trust fund forms part of the estate of the beneficiary if they should die.
Discretionary trust:
CLT/IHT free after 7 years.
At the outset, there is a charge if the transfer is over the NRB (Nil-Rate Band) (£325,000) at 20% if trustees pay and 25% if settlor pays.
The trust fund is potentially chargeable to a 10-yearly periodic charge of no more than 6% and an exit charge when capital is distributed of no more than 6%.
Growth immediately outside of the estate.
Explain in detail the Income Tax and Capital Gains Tax implications of gifting part of their Unit Trust into a discretionary trust for the benefit of the grandchildren.
- Capital Gains Tax Implications:
Gift to a discretionary trust is considered a disposal for Capital Gains Tax (CGT).
Holdover relief is available, allowing the gain on Unit Trusts (UTs) to be deferred.
When the trustees sell the UTs, the heldover gain becomes taxable on the trustees.
The trustee’s gain is calculated as the disposal proceeds of the UTs minus the settlor’s base acquisition cost.
The trustees have an annual exempt amount of £6,150, and the taxable gain is taxed at a rate of 20%.
This diverts the gain from being taxed on the settlor to being taxed on the trustees. - Alternative CGT Treatment:
Alternatively, the gain can be held over again by transferring the UTs to the beneficiaries.
The beneficiaries’ acquisition cost is reduced by the amount of the heldover gain.
The beneficiaries can utilize their own CGT annual exempt amount.
The gain is then taxed on the beneficiaries (grandchildren), likely at a lower rate than the trustees’ rate of 20%.
The beneficiaries would need to make the claim for holdover relief jointly with the trustees. - Income Tax Implications:
Income from the UTs is taxed at a rate of 45% on interest and 39.35% on dividend income above the trust standard rate band of £1,000.
Recommend and justify a suitable strategy for Declan and Carmen to make a gift into trust for their grandchildren for their university fees.
Rec 1: Set up a discretionary trust
Trustees would be Declan/Carmen and/or parents
Justification: Trustees would have full control of funds
No right to access for beneficiaries
Can have grandchildren as a class of beneficiary/will include unborn grandchildren
Outside of the estate after 7 ears The money could be used for other purposes other than university fees, e.g., house deposit
Rec 2: Use UT investments
Use some of cash holdings
Justification: Use UT for gift rather than S&S ISA as UTs are less tax efficient
Can use both their CGT AEAs/locks in gains
Interspousal transfer before encashment/no tax on transfer/Carmen taxed at 10% on CGT liability (if falls within basic rate band) /Declan’s gain taxed at 20% as higher-rate taxpayer)
Excess amount of emergency funds could be used/excess held in cash/does not match ATR
Returns on cash will not keep pace with inflation
Likely to be paying some tax on interest
Rec 3: Invest in an Investment Bond within trust
Justification: Wide range of fund choices
Non-income producing assets/higher trustee tax rates can be avoided
5% tax-deferred withdrawals can be used
Segments/the policy could be assigned to the grandchildren when needed top-slicing/if beneficiary is non or basic-rate taxpayer no tax due on encashment
Explain what a discounted gift trust is and how they can help secure an income in retirement as well as mitigate their IHT liability.
- Nature of a Discounted Gift Trust:
A gift is made into trust, either a discretionary trust or a bare (absolute) trust.
If a bare trust is used, the gift is a Potentially Exempt Transfer (PET), and if a discretionary trust is used, it is a Chargeable Lifetime Transfer (CLT).
The gift is discounted according to underwriting and entitlement to regular payments.
The discount represents an immediate reduction in the estate. - Estate and Investment:
The remaining value of the gift is in the estate until 7 years have elapsed.
The trustees invest the monies in an investment bond. - Income and Tax Consequences:
Declan and Carmen, as settlors, have a right to an income for the rest of their lives or until the fund runs out.
The trustees use the 5% withdrawal facility to provide them with this income, and if kept within the 5%, there are no Income Tax consequences. - Growth and Beneficiaries:
The investment bond is held within the trust for the ultimate benefit of the beneficiaries (children and/or grandchildren) and grows outside the estate of Declan and Carmen. - Secure Income and Access to Capital:
The Discounted Gift Trust (DGT) provides a secure income for life, but the settlors must appreciate that they do not have access to the capital.
An alternative option is a loan trust scheme where a loan is made to trustees, and the growth on the bond is outside the estate.
The trustees can use the 5% withdrawals to provide an income.
Any outstanding loan is always in the estate.
Carmen and Declan/settlors can demand the loan to be repaid at any time, providing access to their capital if necessary.
What factors would you need to consider when advising Declan and Carmen on this aim?
- Estate and Inheritance Tax (IHT):
Estate is worth over £1m, potentially resulting in an IHT liability on the second death.
Gifts could potentially reduce IHT.
Consider their views on gifting outright or retaining some access to capital. - Life Expectancy and Affordability:
Declan and Carmen are in good health and likely to live for 7 years.
They have significant guaranteed pension income and other assets to top up retirement income, enabling them to afford gifting £200,000 outright. - Capital Gains Tax (CGT):
They have a current CGT liability on a unit trust (UT).
They can both use the CGT exempt amount (£12,300) and can use previous losses. - Tax Efficiency:
They have Individual Savings Accounts (ISAs), which are tax-efficient.
Unit trust (UT) investments are less tax-efficient. - Considerations for Timing and Purpose:
Base cost of the unit trust needs to be considered.
Timescales for making the gift and when the money will be needed for university fees. - Asset Allocation and Risk Tolerance:
Excess funds are held in current and deposit accounts or in cash, which may not suit their Attitude to Risk (ATR). - NRB and Discretionary Trust:
The amount they wish to invest is below the Nil Rate Band (NRB).
No upfront tax payable if a discretionary trust is used.
Explain to Declan and Carmen the duties of trustees.
- General Duties:
To hold trust property and administer it for the benefit of the beneficiaries.
To hold the title documents to any trust property.
Everything they do must be for the benefit of the beneficiaries. - Financial Responsibilities:
Invest any cash wisely or pay it out to a beneficiary immediately.
Take account of the standard investment criteria.
Monitor investments.
Keep proper accounts. - Ethical Responsibilities:
Avoid conflicts of interest.
Use utmost diligence.
What further information would you need before you could advise Declan and Carmen in the area?
- Financial Situation and Objectives:
Income required from investments and capital needs.
Current expenditure.
Size of emergency fund required.
Objectives of each of the investment vehicles they hold.
Willingness to transfer more of the unit trust and deposit account holdings to Carmen.
Willingness to invest in other asset classes for tax efficiency. - Interest Rates and Costs:
What interest rate does the deposit or current account pay?
Base costs of unit trusts and withdrawals. - Tax Considerations:
Have you brought forward any losses for Capital Gains Tax (CGT) purposes?
State the factors an adviser should consider when advising Declan and Carmen on any changes to improve the tax efficiency of their investments.
- Utilisation of Tax Allowances:
They have fully used their ISA (Individual Savings Account) allowance for the current tax year.
They are taking a fixed monthly income of £500 from their ISAs.
Declan has a £500 Personal Savings Allowance (PSA).
Carmen has a £1,000 PSA.
Carmen can use the 0% starting rate for savings.
They both have a £2,000 Dividend Allowance (DA) to set against dividends from their unit trust (UT) investments. - Taxation on Dividends:
Dividends received are approximately £6,375 per year each.
Dividends above the £2,000 DA will be taxed at 8.75% for Carmen (if they fall in the Basic Rate Tax (BRT) band) and 33.75% for Declan. - Capital Gains Tax (CGT) Considerations:
They currently have a £140,000 gain on their unit trust (UT) investments, held in equal shares.
Declan will pay CGT at 20% on gains in excess of his Annual Exempt Amount (AEA).
Carmen will pay CGT at 10% if the gain falls within the Basic Rate Tax (BRT) band. - Pension Contributions:
They have scope to invest £3,600 into pensions. - Inheritance Tax (IHT) Planning:
They plan to gift up to £200,000 to grandchildren.
They have a potential Inheritance Tax (IHT) liability of £730,000, which at a 40% rate would amount to £292,000.
Recommend and justify the actions that Declan and Carmen could take to improve the tax efficiency of their current financial arrangements.
Rec 1: Carmen to invest £3,600 pa into a pension
Justification: Basic rate tax relief on contributions
Tax free growth
Flexible benefits
IHT free
Carmen has some unused personal allowance/part of income may be tax free
Rec 2: Partial Interspousal transfer of unit trust.
Justification: Ensure Declan’s dividends are approximately in line with his dividend allowance (currently £2,000)
As Declan is a higher-rate taxpayer he is taxed on excess dividends at 33.75%
If Carmen received majority of dividends, she can use her DA/any unused personal allowance/then only basic rate tax will apply at 8.75%
On disposal Declan taxed at 20% on amount about CGT annual exempt amount (AEA) /Carmen only taxed at 10% on gains that fall within the basic rate tax band
Rec 3: Top up income with encashments from UT up to the CGT AEA rather than ISAs
Justification: Locks in gains/no CGT payable/make use of CGT annual exempt amount at (currently £12,300)
Rec 4: Review fund holdings in UT
- Increase holdings in corporate bonds
Justification: Funds/stocks focused on growth rather than income to minimise taxation on dividends
Corporate bonds provide income/provides diversification/can use their PA’s and Carmen’s 0% starting rate for savings (see question in ‘Other questions’ section below for more detail
Rec 5: Hold more of the deposit account in Carmen’s name only to fully utilise allowances
Justification: Carmen has a PSA of £1,000/Declan higher rate taxpayer so only has a PSA of £500
Up to £5,000 can be taxed at 0% if falls within first £5,000 of her taxable income
Rec 6: Consider NS&I premium bonds
Justification: Tax free/excess above their tax-free allowances can be held in premium bonds
What factors should an adviser consider when reviewing the tax-efficiency of Carmen and Declan’s investments at the next annual review?
- Income and Expenditure:
Level of pension income receiving.
Dividend yield/fixed or dividend payments being received.
Expenditure/level of income required.
Interest on cash savings. - Gifts and Trusts:
How much was gifted to grandchildren/which investments were used/trusts used. - Tax Rates and Allowances:
Current marginal tax rates.
Current allowances, including Personal Savings Allowance (PSA), Annual Exempt Amount (AEA), and the 0% starting rate for savings.
Tax-Efficient Vehicles: - Use of ISA allowance.
Pension contributions. - External Factors:
Changes in external factors, such as legislation changes and new products.
Describe how a Lasting Power of Attorney (LPA) works and the benefits of registering an LPA as soon as possible.
- Requirements and Types of Lasting Power of Attorney (LPA):
Can only be registered while Declan and Carmen have mental capacity.
A certificate from a prescribed person confirming their understanding of the LPA and that they have not been pressured into drawing up the documents is required.
Two types of LPA: health and welfare (effective from onset of mental incapacity) and property and financial affairs (can be used immediately).
They can set up one or both types of LPA. - Benefits and Registration:
Property and financial affairs LPA can be used to pay bills, claim state benefits, etc.
Need to register the LPA with the Office of the Public Guardian, with a fee payable.
Registering an LPA as soon as possible is beneficial to avoid complications. - Alternatives and Appointments:
Without an LPA in place and loss of capacity, applying to the Court of Protection for a Deputyship Order would be required, which can be time-consuming, complicated, and expensive.
Deputies appointed by the court rather than family members.
With an LPA, Declan and Carmen can appoint one or more persons they trust as attorneys, including choosing each other to act. They can also choose replacement attorneys and appoint children in case both fall ill. - Benefits of Lasting Power of Attorney:
LPAs ensure that Declan and Carmen’s wishes are met and provide peace of mind.
What restrictions are there with regard to making gifts under an LPA?
Normal gifts such as for birthdays/Christmas can be made
Larger gifts, for example as part of an IHT planning exercise, cannot be made
Recommend how Declan and Carmen can make gifts to their grandchildren to immediately mitigate their IHT liability.
- Annual Allowances:
£3,000 annual allowance (and previous years if not used) can be utilized to make gifts to grandchildren, reducing the estate immediately.
£250 small gifts allowance can be used to make additional gifts, reducing the estate immediately. - Gifts from Surplus Income:
Make gifts out of surplus income to grandchildren, reducing the estate immediately.
The expenditure must be from income and not capital.
The gifts must be regular and must not affect their normal standard of living. - Potential Exemptions:
If the gifts cannot be covered by an exemption, they will be treated as Potentially Exempt Transfers (PETs).
Explain to Declan and Carmen how a Junior ISA works and why it may or may not be a suitable investment vehicle for gifting money to their grandchildren.
- Account Ownership and Control:
Grandparents are unable to open a Junior ISA directly for their grandchildren. It needs to be opened by the parents, and the parents have control over the account until the child reaches age 16.
If aged 16 to 18, grandchildren can open the account themselves. - Contribution and Gifting Limits:
Declan and Carmen can contribute up to £9,000 for each grandchild per annum (2022/23).
The gift into the Junior ISA is a Potentially Exempt Transfer (PET) and becomes free from Inheritance Tax (IHT) after 7 years. - Investment Options and Tax Benefits:
A Junior ISA offers options for cash and/or stocks and shares, providing a wide fund choice.
All returns within the Junior ISA are tax-free. - Account Management and Access:
From age 16, the child can manage the Junior ISA, but they cannot make withdrawals until age 18.
If the child takes control at age 16, Declan and Carmen will have no control over investments.
At age 18, the Junior ISA automatically switches to an adult ISA, or the grandchildren can fully access the funds.
