Many headlines concentrate on the gross return various investments yield. Yet when income is received from those investments it is, after allowances, subject to income tax. When investments are sold, they are, again after allowances, subject to Capital Gains Tax (CGT) and at the end of the day when we pass away our estate may be subject to Inheritance Tax (IHT).
The true return and therefore the true value to an individual must therefore be the return received net of all taxes. With the recent rapid increase in house prices many more estates will become subject to Inheritance Tax.
I recently came across a lady who was divorcing. She lived in a house that was valued at £900k. When asked what the most important thing to her was, she responded with staying in her house.
An inheritance of £250k was coming her way. Another £200k was needed to buy out her ex-husband from the house she wanted so much. She therefore took out an equity release lifetime mortgage for £200k.
As a divorcee, after taking account of residential relief, her estate will have to pay IHT on the excess over £500k. Currently, IHT allowances are fixed until 2026 and it may be a few years beyond that before a future Chancellor increases the current limits. Assuming the house does not increase in value that is an Inheritance Tax bill of £80k.
The lady in question looks upon mortgages as debt. She has been brought up to believe all debt is a bad thing. She is therefore paying the interest on the equity release lifetime mortgage to prevent the debt from growing.
To pay the interest on the mortgage, each year, she needs to draw over £6k net of tax from her pension. This means she must draw £7,500 a year gross, just to pay £1,500 a year to the Government. If she was a higher-rate taxpayer, she would have to draw £10k each year gross.
The effect of paying the Government £1,500 a year is to ensure her estate pays at least £80k IHT.
If she did not draw that £7,500, her pension fund would benefit from compound investment growth on that amount each year. Is the compounding effect of the tax advantage growth on the additional £7,500 in her pension each year going to be greater than the compounding of £6,000 interest on her equity release mortgage?
On her death she could leave the balance in her pension fund either to her beneficiaries as a lump sum, in which case it will normally be taxed at their marginal rate, or as a dependant’s drawdown fund, in which case it will be taxed at their marginal rate when the recipients make withdrawals. (This is current law which may change in future).
If passed on correctly the inherited pension could incur far less tax than the 40% IHT rate. It is important to understand what options are available and what the actual tax treatments of each option will be. As the client ages, the tax treatment may change, and investment growth may give rise to a Lifetime Allowance charge at age 75.
IHT is payable on the equity remaining in the home. A £900k house with a £200k mortgage means £700k counts towards Inheritance Tax. Offset the £500k nil-rate band leaves £200,000 creating an IHT bill of £80,000.
After around 24 years the compounding effect of the interest will double the mortgage to £400,000. If the house has not increased in value, then its net value for Inheritance Tax will be £500,000.
It would be naive to assume that the house would not increase in value over this time. The increase in value will be subject to IHT apart from any increase in allowances that occur.
Allowing for 2% compound growth on not withdrawing £7,500 each year from a pension adds over £220k to the pension fund. Slightly more than the compounding growth on equity release mortgage. However, £80k has been saved in Inheritance Tax.
Every case will be different, but the above illustrates the true value of holistic retirement planning.
Bob Champion is chairman of the Air Later Life Academy
