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Defusing capital gains: a worked example

Updated by The Investor on April 4, 2022

The UK tax year ends on 5 April. For many people, the weeks before are a rush to put money into an ISA before the year’s annual allowance is lost.

This rush is despite them (maybe YOU?) having already had 11 months to open or add to an ISA in order to enjoy – forever – tax-free interest, dividends, and capital gains on shares.

Tsk. People, eh?

But what about those of us who do dutifully max out our ISAs every tax year? Those lucky enough to have cash leftover – even after making our pension contributions?

Or what about those who inherit a fat wodge, say, and haven’t been able to ISA-size it all yet?

And what about those people (*whistles* *looks at feet*) who years ago were dumb enough to buy shares outside of an ISA for literally no good reason?1

After a few years and a strong stock market, even modest-sized investments made outside of tax wrappers can be carrying significant capital gains.

High-rollers / reformed muppets with this high-class problem – unsheltered assets with gains – should consider using up their annual capital gains tax allowance2 every year – by end of day 5 April.

I call the process defusing capital gains because it helps to nullify a future tax time-bomb.

Keep on top of growing capital gains

In the 2021/2022 tax year, you have a £12,300 capital gains tax (CGT) allowance.

This means you can enjoy £12,300 in gains CGT-free, across all your CGT-chargeable investments.

Remember, CGT is only liable when you realize the capital gain. This happens (in most cases) when you sell sufficient assets to generate more than £12,300 worth of gains (aka profits).

Until you sell, you can let your gains roll up – unmolested by tax.

Deferring gains like this is better for your finances than paying taxes every year.

But it’s even better for your long-term returns to pay little to no taxes on gains at all.

The trick? Sell just enough assets to use your CGT allowance in order to trim back the long-term tax liabilities you’re building up – but not enough to trigger a tax charge.

You may also want to realise some capital losses, to defuse even more gains.

That, in a nutshell, is defusing capital gains.

Remember, taxes can significantly reduce your returns over the long-term.

Yet paying capital gains taxes is also a bit optional, like high investment fees. Similar to high fees, by being vigilant over a lifetime most people can dampen or even sidestep their potential impact.

Let’s consider an example.

Defusing capital gains

We’ve written before about how to manage capital gains by using your CGT allowance to curb the growth of your CGT liabilities. Read that before this article.

Let’s now see an example of how you go about defusing a gain.

Don’t make it harder for yourself! Your broker, software, or a record-keeping spreadsheet can help you track the ongoing capital gains on each of your holdings. I’m showing the underlying calculations below for clarity. Make sure you keep great records if you invest outside of tax shelters! The paperwork can be painful. But it is necessary.

A worked example of defusing capital gains

Let’s say you invest £100,000 in Monevator Ltd – a small cap share that pays no dividend, but whose share price proceeds to compound at a very rapid 30% a year for three years.

(I wish!)

After this period you decide to sell up. You plan to use the money to buy an ice cream van and become a self-made mogul like Duncan Bannatyne.

The question: is it a good idea to defuse or not to defuse capital gains along the way?

Here are two scenarios to help us decide. I’ve rounded numbers to the nearest pound throughout for simplicity’s sake.

Scenario #1: You don’t sell any shares for three years

What if you don’t defuse? In this case your initial £100,000 of shares in Monevator Ltd compounds at 30% a year for three years.

At the end of the third year / beginning of the fourth year your shareholding is worth £219,700. You sell the lot. You have thus realized a potentially taxable gain of £119,700. (That is: £219,700 minus your initial £100,000).

Assuming the annual capital gains tax-free allowance is still £12,300 in four years time – and assuming this is the only chargeable asset you sell that year, so there are no other gains or losses to complicate things – you will be taxed on a gain of £107,400. (That is, £119,700-£12,300.)

The tax rate you’ll pay depends on your income tax bracket.

At the basic rate, you are taxed on capital gains on shares at 10% (18% for residential property). Higher-rate taxpayers pay 20% on their gains (28% on property).

From our previous article, you’ll know that the taxable capital gain itself is added to your taxable income to determine your tax bracket.

The current income tax bands from HMRC:

(Wales has the same bands. Scotland is different – see HMRC.)

In other words, you’ll pay a 10% CGT rate on your gains on shares if your overall annual income is below the £50,270 higher-rate threshold.

You’ll pay 20% on your gains if your total annual income is above £50,270.

Clearly, in our example most or all of the £107,400 in gains is going be taxed at a rate of 20%. So to keep things simple, let’s presume you’re already a higher-rate tax payer from your job.

At your CGT rate of 20% then, that £107,400 taxable gain will result in a CGT tax bill of £21,480.

You pay your tax. You are left with £198,220 after the sale.3

Remember: to keep things simple I’m presuming you don’t have any capital losses that you can offset against this gain to further reduce your liability.

Scenario #2: You defuse your gains over the years

What if instead you sold enough assets every year to use up your capital gains tax allowance?

In the first year your holding in Monevator Ltd grows 30% to £130,000 for a capital gain of £30,000.

Remember: you are not charged taxes on your gains until you actually sell the shares.

You can make £12,300 a year in taxable capital gains before capital gains tax becomes liable.

So what we need to do is to sell enough shares to realize a £12,300 taxable gain, which we are allowed to take tax-free. (i.e. We cannot just sell £12,300 worth of shares).

First we need to work out what value of shares produced a £12,300 gain.

A quick bit of algebra:

x*1.3 = x+12,300
1.3x-x=12,300
0.3x=12,300
x=41,000

So £41,000 growing at 30% results in an £12,300 gain, which we can take tax-free under our CGT allowance.

We need to sell £41,000+£12,300 = £53,300 of our £130,000 shareholding.

You could reinvest this money into the same asset after 30 days have passed, according to the Capital Gains Tax rules. Or you could invest it into a different asset altogether.

In the second year, we start with an ongoing holding of £76,700. (That is, £130,000-£53,300.) Again it grows by 30%, so we end the year with £99,710.

But remember, this ongoing shareholding had already grown 30% in the previous year!

So the maths now is:

x*1.3*1.3 = x+12,300
1.69x-x=12,300
0.69x=12,300
x=17,826

So £17,826 has grown by 30% per year for two years to produce the £12,300 tax-free gain we want to use up our allowance.

We need to sell £17,826+£12,300=£30,126 of the £99,710 shareholding.

In the third / final year, we are down to a shareholding of £69,584, which grows by 30% once more to £90,459.

x*1.3*1.3*1.3 = x+12,300
2.197x-x=12,300
1.197x=12,300
x=10,276

Over the three years, £10,276 has grown by 30% every year to produce an £12,300 gain. (You can check this with a compound interest calculator).

We must sell £10,276+£12,300 to realize this gain and use up our CGT tax-free allowance.

That is, we need to sell £22,576.

This leaves us carrying a holding of £67,883.

In total over the three years we have sold £106,002 worth of shares, and realized £33,900 in capital gains4 entirely free of tax.

Let’s once again assume we still need all our money as cash for the ice cream van at the start of year four, as in Scenario #1.

The fourth year is a new year, so we’ve a new £12,300 capital gains allowance.

But now we are going to pay some capital gains tax.

The £67,883 holding we are still carrying was originally worth £30,898, before it grew at 30% every year for three years.5

We pay tax on the gain only, which is:

£67,883-30,898 = £36,985

We have that personal allowance of £12,300:

£36,985-12,300 = £24,685

Our final (and only) tax bill on selling up the remaining £67,883 stake is therefore:

(£24,685) x 0.2

= £4,937

Compared to Scenario #1, we’ve saved £16,543 in taxes.

After paying capital gains tax we have £62,946 from our final share sale, plus the £106,002 we sold along the way. That gives us total proceeds of £168,948.

Before you start to type something in response to that number being less than the end total in Scenario #1, please read on!

Is it worth defusing capital gains?

I can think of plenty of things I’d rather do with £16,543 than give it to the Government, so I vote ‘yes’. Defusing is worthwhile.

Your mileage may vary.

But note that I’ve worked through a simplified example.

A 30% a year gain for three years in a row is very unlikely, even with winning shares. In reality, even with the best-performing companies or funds you’ll get up years and down years, likely spread over many more than three years.

If you invest a lot outside ISAs and SIPPs you’ll probably also have more than one investment that sees capital gains. So you’ll need to consider your gains and losses across your portfolio to best defuse gains.

Are you a millionaire who invests outside of tax wrappers? Then capital gains issues are a reason to avoid an all-in-one fund, if you want to be as tax-efficient as possible. If you instead buy and manage a basket of separate shares or funds, you may be able to defuse any growing CGT liability by offsetting gains against losses, as well as by using your personal allowance every year.

I’ve also completely ignored the issue of what you’d do with the money you liberate each year if you do defuse your gains along the way.

In fact, I’ve ignored overall returns altogether. I just wanted to show the tax consequences.

As I hinted at the end of the worked example, the eagle-eyed may have spotted that Scenario #1 leaves you with more money than Scenario #2 – despite Scenario #1’s higher tax bill.

This is simply a consequence of ever-more money being left idle in Scenario #2 after annual defusing.

In contrast, in the ‘pay all the tax at the end’ strategy, all the money grows at 30% for three years – clearly a great return – before you pay any tax.

In practice, cash released from defusing capital gains can of course be reinvested (though I wouldn’t bank on getting 30% returns each time if I were you!)

Reinvesting your gains

£20,000 a year of the proceeds could be put into an ISA and thus be free of all future CGT. You can immediately re-buy exactly the same share you defused if you do so within an ISA (or in a SIPP). The 30-day rule doesn’t apply here.

You could also sit on the money for more than 30 days before re-buying the same asset outside of an ISA or SIPP.

Or you could immediately buy something different. Or just keep the proceeds in a cash savings account.

In Scenario #2, the cash released could have been reinvested in the same share in an ISA and/or a SIPP at the end of years one and two for further gains.

So just to complete the circle, if we again over-simplify and assume the proceeds of defusing in my example were reinvested at the same 30% rate, then you’d be left with £214,763 in total6, which is £16,543 more than you were left with in Scenario #1.

Which is: exactly what we saved in taxes!

Fair’s fair?

You might argue I didn’t give the non-defusing strategy the very best shake.

For instance, we could have sold one chunk on the last day of the third tax year, and then the rest on the first day of fourth year, to use up two lots of tax-free allowance.

This would have slightly reduced the tax bill. But selling over two years like that counts as defusing capital gains!

So my example is good enough I think.

The last word

As I say, this was all just a fanciful illustration.

I chose a sky-high annual return number because the alternative was to illustrate a much more realistic 30-year defusing schedule. That’s fine in a spreadsheet, but even duller to work through.

We’re talking taxes here. I don’t want to try your patience.

Incidentally, a few people typically complain whenever I talk about mitigating taxes on investments.

We’re not fat cats here. We’re just ordinary people trying to achieve financial freedom on our own terms in an expensive and uncaring world.

And the reality is it’s pretty challenging to get rich by investing on a middle-class income. You can’t afford to leak money away by paying taxes you don’t have to.

Indeed I’ve been investing for two decades and I can confirm it’s at least as hard as sitting in your million pound house in London that you bought in the late 1990s with a 95% mortgage – at a price that has quintupled since, multiplying your initial deposit 80-fold, entirely tax-free to you – while you occasionally look up from the Guardian to moan about tax-dodging share ‘speculators’.

Tax mitigation is legal and sensible. People can use the money they save however they see fit.

And we admire those who eventually give it to good causes or invest in noble pursuits.

But handing over more than your share to the State just because you weren’t paying attention hardly seems like intentional living.

The bottom line is taxes will reduce your returns, but there are things you can do to reduce them.

Talking of which, reinvesting the money via your new annual ISA allowance from 6 April is one of the very best. Check out our broker table for some options.

Here’s short list of NOT good reasons. Laziness. Trying to save a few pennies in charges. Thinking “taxes won’t affect me” because you only look at one or two years expected returns. Not doing your research on the impact of taxes on returns. [↩]
Also known as your ‘Annual Exempt Amount’, if only by HMRC. [↩]
£219,700 – £21,480. [↩]
£12,300×3. [↩]
x*2.197=£67,883, so x=£30,898. [↩]
£90,077+£39,164+£22,576+£62,946. [↩]

{ 82 comments }

Weekend reading: Curve balls

by The Investor on April 2, 2022

What caught my eye this week.

This week saw the all-important US yield curve ‘invert’. This happens when short-term rates in the bond market exceed longer-term rates – typically two-year bond yields versus 10-year yields.

Is this newsworthy? The Internet news-machine thinks so:

Confession time! I admit I haven’t read all 35,200,000 articles that Google tells me are available about ‘yield curve inverted’.

I’ve read maybe three. Perhaps that’s irresponsible, even if we presume 34 million of them were talking about some previous inversion of the yield curve.

Well that’s me: all rock-and-roll.

Or more precisely… like most active investors I’ve been force-fed developments in the interest rate market daily for at least six months now, like some goose being fattened for Christmas.

Thus the US yield curve finally inverting was about as surprising a development as British Summer Time. (Note: I mean the clocks going forward, not us actually getting a summer.)

Still, perhaps you have been doing better things with your time than reading about rates? Want to catch-up? Here’s a link to those search results. Have at them!

Or else just read this excellent article on the yield curve inversion from Morningstar.

Ahead of the curve

A couple of readers have asked me what I think about this portentous event. Which is flattering, but also like asking Richard Dawkins to tell you your horoscope.

This stuff is not really my bag. However in my defense that’s a strategic decision.

You see, I don’t really think the US yield curve inverting is signalling anything we don’t already know.

And nowadays I doubt it ever could.

I’m old enough to remember when – outside of investment banks, trading floors, and economics classes – the only people who ever mentioned yield curves inverting were weirdos on discussion forums who’d at some point presumably escaped from banks, trading houses, and classrooms.

In those quieter days, the yield curve inverting was maybe a useful tell.

But honestly, I now expect my mum to tell me about the yield curve inverting when I call her this Sunday. In-between her spring gardening plans.

In theory, the US yield curve inverting is worth watching for as historically it’s presaged recessions.

In theory, again, that’s because an inverted yield curve indicates the market expects interest rates to decline in the longish-term (ten years or so out) which is the sort of thing that happens in recessions. (Due to central banks cutting rates and also market forces, as there’s a bid for safer assets).

And having advance knowledge that a recession is coming is – again, in theory – useful for investors, because recessions are bad for at least some markets.

But.

Curves in all the right places

For starters, the yield curve has to be inverted for a while to matter. And even then it can give false positives.

But rather than listen to me waffle on about the empirical evidence, have a look at this summary from the Chicago Fed. It’s pretty compelling in arguing that yes, the yield curve inverting probably does indicate a coming recession, but no we don’t really know why.

(That’s not be confused with ‘people won’t tell you they know why it forecasts a recession’. People most certainly will. Even I just gave one reason above. People are always very ready with a Why.)

Let’s just agree for now that the yield curve inverting is indeed a strong indicator of a coming recession. Does this really tell us anything new about the US or even the global economy?

I mean compared to all the information we already have about central bank plans to raise interest rates, and the soaring inflation that is causing the cost of living to skyrocket around the world?

Oh, and energy supply problems and the war in Ukraine?

I think you might accuse the yield curve of rather gilding the lily.

We know the US central bank is aiming to raise rates at least half a dozen times. If the bond market hadn’t reacted to that by pushing up short-term rates then that really would be worrying.

We also know bad times eventually follow good times.

Personally I’ve felt recent US GDP growth was being ginned up by restocking and other artifacts of exiting lockdown, for instance, and thus that there would always be a cooling. (This was also why I expected inflation to have started to fall by now, albeit Russia has done for that).

A recession is just technically defined as two quarters of negative growth. It doesn’t need to mean dust bowls or Hollywood movies about Michael Burry shorting Wall Street.

The UK situation is murkier because of the impact of Brexit, but for what it’s worth our yield curve is flat rather than inverted, so far. But nobody watches the UK yield curve much.

Behind the curve

What investors – and our curious readers – really want to know is what does this mean for stock prices?

Indeed some pundits seem to take it as read that the yield curve inverting is predicting not a recession but a stock market crash.

However this is not the case. If anything, I think it’s a bit bullish.

First there’s data to suggest that. For example have a look at these tables showing that US stocks usually rise over most periods following a yield curve inverting.

It’s also logical, at least to me, that markets would rally in the wake of the yield curve inverting.

Why?

Because by the time the yield curve has inverted really everyone knows everything. Worries about interest rates have rumbled on for months. The yield curve flattening was kind of interesting in 2021, but now it has finally inverted is that dramatically more interesting?

It’s not irrelevant. But it’s the continuation of a trend, rather than a shocking bolt from the blue.

Shares often fall in advance of a recession – which is perhaps just what we’ve seen this time – and people have already noticed the economy has been having it ‘too good’, which is what we saw with all the euphoria in the US in 2021.

And if share prices are already lower, then they are already discounting bad news.

For example I was noting well before Christmas that there had been an almighty crash in high-flying growth stocks that was likely to spill into the wider market. A few readers scoffed that their trackers hadn’t moved more than a percentage point or two. Hence they weren’t bothered at all.

(Which, by the way, is totally fine. Having readers not being concerned about this stuff is an aim of this site! I’m the weirdo here.)

Anyway, as we all know the past three months did actually turn out to be quite a bit rougher. We saw technical corrections for many major stock markets and even a roughly three-second long bear market for the US Nasdaq tech index.

Shares have since recovered quite a bit, despite further bad news. And now the yield curve is inverting, to tell us what you really needed to know six months ago to do much useful with.

Remember, you need to buy the rumour and sell the news if you’re playing the active game. (Which, again, most people really shouldn’t).

Otherwise you’re playing the reacting game. Also known as the ‘sell low and buy high’ game. And that maths doesn’t work out so well.

To be clear I am not saying we’re definitely set for a stock market rally, or that it was obvious shares would wobble in early 2022.

I’m saying one can make vague probabilistic bets about such things, if that’s your wont.

But given that nobody really knows until everyone knows – because it’s happened, because a yield curve has inverted, say – then reacting to this stuff after the bets are in is a bit futile.

You’re better off sticking to your regular investing plan and leaving well alone.

Flattening the curve

Finally the other reason to be wary of acting on this particular yield curve inversion is that it probably reflects in-part some funny business regarding the US Federal Reserve.

I don’t mean anything nefarious. Rather that, as we all know, via quantitative easing and more recently quantitative tightening central banks have been manipulating the yield curve for years.

So it’s hard to compare today’s yield curve shenanigans with your grandma’s yield curves.

Can the US Fed and other central banks get out of the near-zero rate era and tame inflation without triggering an economic downturn?

The Economist has its doubts and so do I.

But I don’t think it means investors need fear a disastrous future, nor even change what we’re doing. At least not if you had a well-balanced portfolio to begin with.

Many companies have been posting mega-profits for the ages. They have the margins to cope with inflation, take a bit of pain, and balance sheets to get to the better times.

Bonds have finally faced a bit of a reckoning. But in the long-term lower bond prices mean better returns due to higher yields. You’ll also notice that so far this bond market crash doesn’t feel anything like the equity slumps of 2000 or 2008 or 2020. Equities are always the riskier asset.

Inflation is what really hurts the return from bonds. It hits the nominal return from shares, too, of course, but shares are expected to deliver higher returns than other assets over longer-term periods, which is why they have eventually outpaced inflation.

Shares don’t hedge against inflation, in my view, but rather they beat it. Subtle difference.

Maybe this time it’ll take a while for that to happen, or the recession will be worse than I expect, or some new awful thing will roll along and knock us and our portfolios for six. So stay diversified.

Concentrate on keeping an income coming in and stopping your outgoings getting out of control.

However I wouldn’t fret too much about the yield curve inverting. It is only telling us what we already almost certainly knew.

Have a great weekend!

[continue reading…]

{ 23 comments }

Social care costs: how they impact retirement finances – case study

by The Accumulator on March 30, 2022

This is part five of a series on how you can plan and pay for social care costs in later life.

Part one explores why your social care needs probably won’t be funded by the state.

Part two decloaks the social care funding means test. How does it treat your assets and what’s excluded?

Part three identifies the key social care thresholds. These tipping points decide your funding fate.

Part four unpicks how to estimate social care costs using available data.

This post is a case study showing how my retirement plan copes when one of us goes into a care home. I hope the thought process proves useful to anyone facing these choices, or who wants to stress-test their own finances.

Oour previous post explained how to estimate a ballpark number for your social care costs. With that number in hand, you can test your expected retirement finances.

Can your plan withstand the shock of you – and/or a loved one – needing long-term care?

I’ve tested my own finances as an example. The exercise gives me hope we’d survive, should we need to. But not in the way I expected.

For my stress test I’ll model the financial shock of me going into a care home. Meanwhile Mrs Accumulator will hold the fort in our real home.

Let’s assume I’m 85 when I go in. My chance of needing residential care increases drastically at that age.

The average life expectancy for an 85-year-old male care home resident is three years.

I’ll model what happens over six years because:

The average life expectancy for female residents is currently four years. Modelling extra years will be useful for female readers.

There’s a chance I could hang around annoying people for longer anyway.

Care home cost inflation is 5% a year.

I’ll use today’s figures for my expected retirement income, care home costs, and the social care system. These are the best proxy I’ve got for what could happen later in life.

However, I’ll use the new social care thresholds and cap proposed for England from October 2023. I live in England and I have to assume this shake-up will be closer to the truth than the current bands.

The UK average self-funded care home cost is around £40,780 per year. That’s according to the process we examined in our article on estimating the cost of care.

Reminder: this guesstimate is for someone who does not qualify for state funding.

For simplicity’s sake, I won’t customise that figure by my region for this case study.

I won’t look at the worst-case cost scenario, either. (Think £68,694 for dementia care in a south-west of England nursing home. I’ll model that one on a dark and stormy night when I truly want to scare myself.)

The means test assesses financial resources held in my name, plus 50% of anything held in joint accounts.

Because Mrs TA needs a place to live, our home is not on the line in this scenario. It’s not sucked into the means test so long as she stays there.

The means test classifies my resources as income and capital.

In the crazy, budget-necrotising world of social care, those terms don’t refer to the standard definitions of income and capital.

Learn how this applies to you in part two: how social care funding works.

State support is wiped out if I have too much income or too much capital.

Let’s look at my social care scoreboard.

Income

This is made of two components in my case.

£300,000 defined contribution pension – my half of The Accumulator household’s pot.

My plan is to drawdown approximately £12,000 inflation-adjusted income per year using a 4% sustainable withdrawal rate.1

We’ll soon see that local authorities aren’t much interested in the 4% rule. They can claim my income is far higher.

£9,628 a year full State Pension.2 Hopefully the State Pension is still a thing when I’m 85.

That’s it. That concludes the voting from the income side of my finances.

My net income is therefore £19,816.

Capital

£100,000 in stocks and shares ISAs. This is from the 25% tax-free lump sum (I will have) carved from my SIPP.

I intend this pot to deliver £4,000 a year in tax-free income. But it becomes a liability when viewed through the lens of social care funding. I’ll explain why below.

Our only other capital asset is the house. But that’s disregarded from the means test, because Mrs TA wants a roof over her head. (Get her!)

If Mrs TA goes into residential care too or passes away, then the house is fair game.

Capital over £100,000 immediately rules out state support in England from October 2023. Currently the social care thresholds are meaner in England. They are different again in the other home nations.

Capital under £20,000 theoretically rules in state support. But that’s only after most of my income is deducted from the care home cost. We’ll come back to this.

Between those thresholds you’re in the netherworld. You might be eligible for some funding. But it’s fast whittled away by every chunk of your capital in this grey zone.

I have £80,000 in the threshold sandwich.

That doesn’t bode well for my chances of getting support.

Means test says “no”

Because I’m not ruled out for state support on capital grounds, the system shifts to rule me out on income grounds.

The cost of my care home is £40,780 if I have to fund it myself.

But the maximum funding available is £29,128. That’s the cost the local authority would pay for the same care – due to its superior buying power.

The system doesn’t care that self-funders pay a 40% higher premium on average than do local authorities.

If my means-tested income is over £29,128 then I’m footing the entire bill.3

My actual income is £23,816, including my ISA withdrawal rate.

But my means-tested income can be assessed as £56,489.

[Rubs eyes in disbelief]

Surely there’s been some kind of mistake?

Sadly not…

My means-tested income has been inflated by two mechanisms:

The tariff income penalty levied on my £80,000 ISA capital caught between the social care threshold jaws.

Lifetime annuity rates that can be used to assess my pension income, instead of my chosen drawdown.

Open market annuity quotes indicate the income for an 85-year old can be assessed at a much higher level than would be generated by my sustainable withdrawal rate.

Income payable towards care home fees: a quick aside

Regardless of your capital situation, your income above £1,295 a year goes towards your care home fees.

The sliver you keep is known as the Personal Expenses Allowance (PEA).

If your means-tested income minus the PEA4 is less than the local authority’s care home cost, then the council will make up the difference.

Should your means-tested income be higher than the local authority cost (plus the PEA) then you’ll pay the whole bill.

If your actual income is less than your social care costs then it’s all consumed bar the £1,295 allowance.

The care cap could eventually come to your rescue in England. However even that’s a long shot. See below.

Tariff income calculation

Between the social care thresholds, every £250 of capital (or part thereof) adds £1 per to your means-tested income figure.

My tariff income works out like this:

£100,000 (ISAs) – £20,000 (lower threshold) = £80,000.

£80,000 / £250 = £320 per week tariff income added to my means-tested income.

That’s £16,640 in year one (as opposed to £4,000 ISA income I’d expect to withdraw).

£16,640 tariff income added to my net income of £19,816 catapults me far beyond the boundary for support.

That boundary is £29,128 (local authority care home price) plus £1,295 (Personal Expenses Allowance).

Because I’m now classified as a self-funder, my care home bill will actually be £40,780.

I don’t have the income to pay those social care costs. So I’ll end up running down my ISA assets to square the circle.

Still, once I’m below £20,000 in capital, tariff income ceases to be a problem. (That shouldn’t take long at those prices.)

The thornier issue is how my defined contribution pension is valued by the local authority…

Lifetime annuity income calculation

Social care guidance allows local authorities to calculate your pension pot income as:

the maximum income that would be available if the person had taken out an annuity.

This applies once you reach State Pension Age. The local authority can get an annuity estimate from the Government Actuary’s Department or your pension provider.

To see how that plays out, I checked the annuity rates. Reminder: I’m an 85-year-old male with a pension pot of £300,000. I used the Money Helper annuity comparison tool.

The tool comparison flashed up an income of £38,860 for a level annuity with no protection whatsoever.5

In other words, the income wouldn’t rise with inflation. Worse, if I popped my clogs the day after signing up, the annuity provider would bank every penny from my pension pot. Mrs TA wouldn’t get a thing.

That looks like a bad bet for a guy with a life expectancy of three years.

Add the £38,860 annuity to £16,640 tariff income and my means-tested income soars to £56,489.

I have no chance of state support until I tailor my finances to the means test.

Is there a better alternative?

If you can’t beat them, join them. At age 85 an annuity probably will provide a better income than my prudent withdrawal rate rules.

I just need to buy one that takes care of Mrs TA, too.

Annuity protections that provide for partners, the kids, and other beneficiaries mean I won’t match that £38,860 quote.

That’s fine because:

If I buy an annuity then the local authority must count that as my income.
They can’t cook up some shady max income that I don’t actually have.

Sacrificing annuity income for partner protection looks like a good trade-off when my life expectancy is foreshortened.

I can secure a £22,346 income from an escalating annuity bought with my £300,000 pension pot.

The income rises with RPI-inflation – handy if I linger – and will pay the same escalating amount to Mrs TA if I don’t.6

Inflation-protection, partner protection, a far higher income versus drawdown – the much-maligned annuity has a lot going for it once you reach a certain age.

Value protection options also enable you to rig your annuity to pay out a lump sum to your family to sugar the pill of your passing. That limits the threat of the annuity company snaffling all your capital should you prematurely push up daisies.

There’s also an immediate needs annuity. This is designed specifically for paying long-term social care costs. The main advantage is your income is tax-free: if it goes straight to a registered care provider.

I haven’t researched these products yet. They may well be better for value for money than the annuities I looked at.

(Monevator contributor Planalyst tells me that a financial adviser would normally recommend an immediate needs or deferred care annuity to deal with social care ahead of other annuity types.)

It’d be worth thinking about annuitising the ISA assets, too.

Beware of Catch-22s

There are other SNAFUs to investigate such as:

Raising income slightly, only to lose benefits and worsen your overall position.
Blundering into a solution that has an unexpected tax sting.

Financial barbed wire like this is hard to untangle.

Paying your social care costs is one of those times it’s probably wisest to seek expert financial advice on your situation.

Other options worth considering include partial annuitisation, or drawing down my pot at an accelerated rate.

So where does that leave us?

The case study must go on! So let’s assume I go into the care home having bought an escalating annuity.

By purchasing the correct protections, Mrs TA and I are better off. And we eliminate one of the means-tested income problems.

The other problem is tariff income. That solves itself by year five. See this fun snapshot of my care home years:

A table that shows how social care costs escalate over time, the effect of the means test, and when state funding kicks in.

Assumptions

Self-funded care home costs rise by 5% annually.
Local authority care home costs, Daily Living Costs, State Pension, and Personal Expenses Allowance all rise by 3% annually.
Social care cap, social care thresholds, and Personal Allowance – no annual inflation rise.
RPI-linked escalating annuity – 3.5% annual rise.
My life expectancy is three years. But I’ve modelled six years because I hit the social care cap towards the tail of year five. Who would want to miss that?

Here’s a link to my social care costs spreadsheet. Try running your own numbers.

The edited highlights

My ISA capital is obliterated by my self-funder costs in years one and two.

Capital falls from £100,000 to £20,000 by year three. The proceeds of this pay my care home fees for the first two years.

Tariff income is out of the equation from year three. I qualify for around £2,440 of state support from then on.

I’d aim to keep my ISAs as close to £20,000 as possible. Capital below that lower threshold isn’t captured by the means test. Anything above weighs me down with tariff income at a penal rate.

My actual income isn’t enough to pay for the care home in any year. Hence I drain the ISAs early on. I rely on some state support after that.

From year three, I’m no longer a self-funder. I pay the local authority’s care home price thereafter. That price – minus my assessed income – is the level of state funding I get, until the social care cap is reached.

My assessed income is my net income minus the Personal Expenses Allowance – once I’m no longer dogged by tariff income.

That leaves me with £1,373 income to spare in year three, plus a dribble of ISA income. That’ll all be gobbled up by hidden charges, top-ups, Mrs TA’s gin problem and so on.

Off-stage, the switch from self-funder to state-funded status could be a problem if the local authority and my chosen care home can’t do a deal.7

The local authority doesn’t have to pay my care home’s price. It can offer me an alternative home it declares is more suitable and cost-effective.

I’d be welcome to stay where I am if I could afford it. As I couldn’t from year three, I’d be at the mercy of the local authority’s decision.

What happens to my income?

Yet another grey area is what happens to the income I’m not spending on care homes (years one and two) because I’m burning my ISA capital on the fees instead?

I assume I can ship it to Mrs TA to pay the bills back at base without being accused of deprivation of assets. (That’s social care system speak for: ‘you’re diddling us’.)

Perhaps then Mrs TA could use some of that income to grow her ISAs?

I don’t think I’d be depriving the local authority of capital or income. My capital is paying fees and my income will be the same next year.

But I’m no expert. I’d really want specialist advice before making any such move.

My spare income could also pay for top-up care. I might go for this if the local authority and I disagree on my needs. I suspect I have a higher opinion of myself than the council does.

One thing that I should not do is stick the extra cash in a bank account. It’d only get counted as capital at the next assessment.

The social care cap cavalry arrives towards the end of year five.8

It’s sobering to remember my last year on this Earth is projected to be year three, according to the life expectancy data.

And also that government headlines imply your care costs are state-supported once you hit the magic £86,000 mark.

My social care costs will reach about £175,000 before the cap puts a leaky lid on it.9

If this same level of ‘protection’ applied to birth control, I’d be a father of five by now.

Progress to the care cap is delayed by all the exclusions. Namely: the self-funder premium, Daily Living Costs, state funded payments, and top-up fees.

My state-funding shoots up in year six once the cap closes. I go from £2,545 to £21,711 in support.

I’m only responsible for the Daily Living Costs once I’ve hit the cap. I can almost cover that with my State Pension.

Hitting the cap leaves me with more disposable income – £20,619 instead of £1,457.

We’ll put it towards a new exo-skeleton for Mrs TA. Hopefully that’ll keep her out of the care home.

House money

If the house comes into play then our capital shoots sky high. We’ll pay full self-funder fees from its value until we reach the cap.

In that case, we’d need to check the merits of a deferred payment agreement versus commercial equity release versus selling it.

Those we leave behind

My main concern is that Mrs TA has enough to live on while I’m living it large in the care home.

Simply put, an individual can’t live as cheaply as two.

The Retirement Living Standards research suggests that a person living on their own needs 68% as much as a couple. As opposed to 50% as much.

The Retirement Living Standards’ £30,600 ‘moderate’ band is a good proxy for our standard of living. A single person needs £21,000 a year to maintain that heady lifestyle.

Assuming Mrs TA’s income* mirrors mine, it stacks up like this:

£12,000 @ 4% withdrawal rate from £300,000 pension pot.
£4,000 @ 4% withdrawal rate from £100,000 stocks and shares ISA.
£9,628 full State Pension.
£23,816 total after tax.

Mrs TA scrapes over the £21,000 line, thanks to her State Pension.

To cover her without that headroom, we’d be looking at equity release or annuitisation.

That wouldn’t be such a hard decision for us because we don’t have kids. There’s no need to live like poor church mice at such a grand old age.

++*Monevator minefield warning ++ In a futile effort to streamline this case study, I glossed over an important reality. The bulk of The Accumulators’ joint pot is in my name. You can assign 50% of your pension income to your spouse or civil partner so it doesn’t count towards your means test. But you’d need to do that when you were still healthy, and a sub-50% share isn’t disregarded from the test. So how does that work if your pot is less than 50% bigger? And your partner needs, say, 40% of your income to pay the bills? I guess you could fork over 50% anyway, and make it work together to establish a prior pattern of spending before the forensic accountants inspect your bank statements. But who organises their finances like this? Unmarried couples must also watch out. As usual, they don’t benefit from the same financial protections.

Stress test passed

The good news is that our retirement finances can deal with the social care costs racked up in this case study. Assuming my starting assumptions are accurate.

Yay!

I’m heartened by that. Because we’re hardly operating at the luxury end of the market.

Of course I haven’t modelled every nightmare scenario. Nor even the more likely one – needing care in the home.

Perhaps that can be my new hobby.

The short version: higher costs simply burn up my ISA faster, and increase state support thereafter as my income is swamped by higher fees.

If the house is mean-tested then its value saves the state stepping in until I hit the cap.

The main benefit of greater resources is paying for a higher standard of care than the basic state package.

A high income can also be used to protect your capital assets (such as the house) from being chewed up by fees. Once the cap is hit then your house is safe.

Anyone who triggers a high proportion of state support from the outset will take much longer to hit the cap. Because state funding does not count towards your cap target, you could be left subsisting on the miserly Personal Expenses Allowance for years and years.

If your income is too low to meet the Daily Living Costs then they could consume your home’s value. Those costs are never capped.

Better plan for care

The standout takeaway for me is the system’s eye-gouging complexity. This is not something anyone should have to cope with while in failing health.

So long as social care remains in this patchwork state, I think it’s worth planning ahead of time.

My dream scenario is that we agree this is no way to carry on as a society. The cost of long-term social care is the UK’s worst lottery. None of us know if we’ll be left holding a losing ticket.

A risk of catastrophic outcomes for a minority is best handled collectively. Hopefully we’ll agree to create a proper safety net. One that protects everyone from a bad roll of the social care dice.

Next post: Planalyst runs her rule over various financial products that can help pay for social care.

Take it steady,

The Accumulator

Bonus appendix: social care funding – the diagram

This flowchart graphically simplifies the complexities of the social care system. It will help you follow this series:

The reality is a little more nuanced. But I’m simplifying a few aspects in a vain attempt to stop this case study imploding. Blame the byzantine absurdity of the social care system. [↩]
2022-23 figure. [↩]
After deducting the Personal Expenses Allowance from my income. [↩]
The PEA is slightly more generous outside England and is called the Minimal Income Amount in Wales. [↩]
The annuity was a single guaranteed income product. [↩]
It’s a joint income annuity that pays 100%. [↩]
It’s possible I could qualify for local authority rates before year three. This is a North Sea sized grey area. I’ve assumed I remain a self-funder in years one and two to keep things less murderous than they already are. [↩]
For sanity’s sake I haven’t modelled the exact moment I hit the £86,000 social care cap. [↩]
If I assume the social care cap rises at an inflation rate of 3% I won’t hit it until some point in year six. Your outgoings before the cap is ‘officially’ reached are worse if you self-fund for longer, for example because you have more in capital. [↩]

{ 32 comments }

How to spend money

by The Investor on March 28, 2022

During the final few years of my extended graduate student lifestyle, I wondered if I’d ever spend money like a normal person.

House-sharing in my early 40s was still fun. I lived with an old friend – a should-be standup comic – and my picaresque romantic life was heavier on the romance than the ‘life’ part. So I never had to level up my spending on that account either.

My income was good if unspectacular by London standards. It dwarfed my needs.

I was lucky that my job provided global travel and a paid-up social life.

Combine a lifetime of saving with investing mania, and any rare splurge on a fancy meal or even a modest holiday felt like scrumping apples from an orchard.

I had growing resources at my back. But I had no desire to deploy them.

Spending money just seemed to create hassle, anyway. A new gadget to learn, or an expensive suit that needed adjusting, taking me back into the sight lines of salesmen.

I had a pet theory that the only sure way to get value from money was to either eat it via a favourite restaurant, or to take a black cab home afterwards. (This being before Uber or even Deliveroo).

Eating out and avoiding the night bus delivered the most bang for my hoarded bucks, not that I did much of either.

Everything else had catches.

What became of the likely lads

I appreciate that to some the notion of a nearly-middle-aged man living with his university friend and relishing a free-range chicken from Waitrose as a treat will seem odd. If not pathetic.

But it is not that strange in the mildly less conventional urban circles I moved in.

For a long time the unusual thing versus my peers was my portfolio, not my living arrangements.

However time did eventually tell. Generations of friends paired-up and left London. (And got divorced, but that’s another story.)

And as Morrissey once sang, the joke that me and my other half on the council tax bill were already a married couple wasn’t quite so funny anymore.

One acquaintance pitched our set-up as Men Behaving Badly meets the IT Crowd.

Another – an ex-girlfriend turned confidant – described me as chrysalis in suspended animation.

I mostly brushed this off, lying on our vast sofa watching The Wire on a Sunday night while they fretted with kids or dreaded work on Monday.

Indeed that sofa was a case in point. My housemate got it from his high-rolling sister. She couldn’t take it with her when she emigrated with her banker husband and kids to South East Asia. We got it ‘on loan’ but it was obvious she’d never want it back.

We marveled that it cost “over £1,000”. My friend almost bragged as much to visitors.

Strangely, they never seemed that amazed.

Soon enough I’d find out why.

Can’t stand me now

You see, the end was near for my long experiment in responsibility-free living.

One day I showed my pal a Help to Buy scheme and this time it grabbed his attention.

I suspect he was getting fed up with our take on The Two Ronnies, or at least becoming more sensitive to the innuendo.

Also, with my financial hat on I’d been boring him for a decade about how he should convert his dependable salary into a mortgage.

Finally he listened.

Six months later I was able to rue my advice at my leisure as I knocked about the house on my own. Having a place to myself did make a nice change. But I didn’t like the rent at all.

I decided to bite the bullet and to buy my own place, too.

My eccentric finances made this non-trivial. But I wangled a mortgage and bought a roomy space that four years on I’m still smitten with.

What a waster

Breaching my fortress balance sheet with a mortgage after a lifetime of no debt upset my equilibrium. I’m still adjusting my investing, for instance, to reflect my changed risk tolerance.

But it was spending money to make my flat into a home that presented the biggest challenge.

As I said, for many years I was fortunate to travel with work. Being in a somewhat trendy industry, we invariably stayed in hip boutique hotels.

I loved them and I wanted my own home to be as nice. I knew this would mean spending money.

But I didn’t. Not to begin with. Perhaps I couldn’t.

At first I slept on a camping mat. Snow piled up against the bi-fold doors.

I didn’t have any curtains.

My then-girlfriend got sick of this pretty quickly, so I bought a mattress. It arrived in a box and I slept like a dream.

Specifically, like someone dreaming of a dining table and perhaps a TV instead of a laptop.

I told myself and others that I was gathering my interior design thoughts. And it was true I now spent my weekends in the shops – places like Habitat and Heals and John Lewis that had previously been about as substantial to me as the facades of a Hollywood set.

The truth was I was reeling from the cost of moving – especially the obliteration of tens of thousands of pounds due to stamp duty – and I needed to regroup.

Don’t look back into the sun

It took a while. But in time I did furnish my place in the style I aspired to be accustomed to. I even splashed out on a wish list item – a coffee machine – that still makes me smile four years on.

Most people come to personal finance blogs to hear how to save and invest.

But from years of the Monevator comments, I know I’m not the only one with a not-spending habit.

So here’s how I learned to actually spend money without ruining my long-term plans.

1. Partition your finances

Unlike my co-blogger, I don’t budget. For most of my life a budget would have been as gripping as a celibate monk chronicling his sex life. I invest almost everything I can, and if I need to spend there’s money left in the current account.

I pay myself first, second, and third!

However I do track my net worth and my portfolio (and sub-portfolios) via a real-time spreadsheet.

So I created a new entry for flat furnishing. I detailed all the purchases I could think of, estimated the cost of each, and bumped the total up by 50% as a buffer.

This money was now separately bucketed for doing up my flat.

This got it into my skull that my spending would be contained. I could see my money mostly stayed invested. And because I was outfitting my first home as a 40-something after years of saving rather than straight from university, I was lucky in that the budget was only a small share of my net worth.

2. Spend money slowly

Unfortunately for you – unless you are one of half a dozen people I know who could be reading this – you haven’t been to the most beautiful home in the world.

But I have. I still have daydreams about it.

A relatively modest finca in Spain, it was refurbished and extended by the mother of another of my exes. (See, there are perks to serial heartbreak.)

Besides having an amazing eye for detail – and a bargain – she explained that the secret was to go slowly. To see how you use the space. How the light falls. And so on.

That was all a good excuse to spread out my spending and put up with short-term inconvenience while I decided what to buy for the best.

This gentle pace definitely made it easier to spend compared to bleeding cash every weekend.

3. Spend out of income (including future income)

Another benefit to drawing out my spending was I dipped into my savings less than I’d anticipated. It was more that I redirected new income towards each month’s project.

My saving rate slowed, of course. But that was pretty invisible, and easier for a lifetime saver than seeing my bank balance go south.

(To get a sense of just how deeply my saving habit runs, I once worked out that some of the deposit on my flat originally came from a teenage paper round.)

I also put a lot of spending on a 0% credit card. There was no interest to pay for a couple of years. I ran this into five-figures. That might seem irresponsible but – without wanting to sound like a dick – even four years ago it was only as much as a daily fluctuation in my portfolio.

Before the term was up, I transferred the balance to a new 0% card for a small fee.

Honestly – with inflation running at 7% I’m happy to kick repaying this into the long grass.

4. Amortize everything

I soon learned the reason our old £1,000 sofa didn’t faze anyone is that because even for a very big sofa, a grand is not especially indulgent.

I spent several times that on a leather one with a three-month lead time from an Italian factory.

Buying this sofa did give me pause. I wondered who I’d become. I was not actually running a boutique hotel, after all. This was spending on expenses, not an investment for income.

However it was a very well-made and timeless sofa. I estimated it would last me at least five years and very probably ten. A few years in, my guesstimate is looking good.

Buying a big TV for £700 – even in the Amazon sales – was similarly hard for a lifelong saver.

But spending £140 a year to own a great TV (assuming a five-year lifespan) was palatable.

Again, for most of you this is trivial stuff. For me it was a breakthrough.

5. Consider the Joneses…

I thought of other people and what they owned and spent far more during this period.

Thinking of how certain better-off friends had been through this spending cycle several times – they were onto their fourth home and at least their third sofa – made me appreciate it was normal.

I was still being sensible and frugal-minded, I told myself. I was only now getting to this, and I was mostly buying stuff that would last.

And I have no intention of moving again anytime soon.

Clearly this was a life-phase I had put off. The savings had been banked and compounded, but now it was time to spend.

6. …ignore the Kardashians

All that being said, I was careful whose example I looked to.

In your early years after leaving education, you and your mates are mostly in the same boat. But over time – definitely by your 30s – the divergences emerge.

Some of you are still trying to find your balance at the start of an egg-and-spoon race.

Others are halfway down the track and apparently competing in a different sport altogether.

So I was careful who I compared my spending against. For example I’m pleased a couple of my friends have made several million; I put them out of mind when furnishing my flat.

Obviously I also took no lessons from those who’d always lived well beyond their means.

7. In the long run we’re all dead

I have an old friend with a divergent life and location who I only see once every couple of years.

When we do meet up he never fails to remind me how a few years ago I said we’d probably only see each other another 20 times in our lives.

My friend was shocked by the maths. But I’m very future-orientated and think this way all the time.

Being forward-focused is why compound interest is my North Star, and Buffett’s Folly my downfall.

Everyone comes to understand their mortality sooner or later. Maybe it’s the death of a parent. Maybe it’s the Twitter thread I saw yesterday where someone else ran the numbers just as I do.

Thinking about how I’d waited 20 years to kit out my first home made it easier to get spending. But thinking how long I had left to enjoy it made me think – perhaps for the first time – about what I was really accumulating all this money for, beyond wanting to be financially free.

That’s a weighty subject for another day.

But life changes. Don’t put everything off forever.

Up the bracket

Nowadays I find it easier to spend money. Buying and furnishing my flat – helped by the tactics just detailed – seemed to break some kind of spell.

Today I’m more likely to buy something because I want it, rather than only when I need it.

I appreciate that I’m saying this from the privileged position of financial security. But I don’t feel any great shame about that.

I was fortunate to be born fairly smart and to good role models in a safe, capitalist country. But beyond that I’ve earned and saved every penny.

For many years I heard about friends’ swanky holidays, smiled at their new cars, and admired their shoes and handbags. All the time shopping myself for yellow-labelled food at the supermarket and bargain clothes at TK Maxx.

And guess what? I still enjoy a pot of marked-down pesto as much as I used to. I’m no spendthrift.

The difference is that today, if I really want to make some pasta and there are no bargains to hand, I’ve learned how to bite the bullet and just buy it.

Bon appetite!

Have you get on a mental tips or tricks to help with sensible spending? Please share them in the comments below.

{ 33 comments }

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