The Rule of 72 – The Time Value of Money

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Introduction

The Rule of 72 is a great way to help plan for the future. It is a quick and easy method for calculating the impact that growth and inflation can have on your money and other investments.

Compound Growth/Interest

The rule can be applied to investments where the investor is enjoying compound growth. Compound growth, in its simplest terms applies in cases were “money makes money”.

For example, with a savings account you receive an annual interest rate (return) and for the sake of this article we will consider the scenario where you invest £1000 into a savings account and leave it for a number of years with it enjoying an interest rate of say 5% net (those were the days!)

After year 1 your money will have grown to £105.00 (£100 plus 5%) – at the end of year 2 your money will have grown to £110.25 (£105 at the start of year 2 plus another 5% interest. This is COMPOUND INTEREST – your money has earned money – the £5.00 interest received at the end of year 1 has itself earned 5% interest; in this case the £5 has earned 25 pence interest.

The Rule of 72 – how to use it

To work out roughly how long it will take for a given investment to double in value, simply divide the interest rate being received into 72 – this will give you the length of time required for money to double in value.

For example, of you are receiving 6% net interest per annum your money will double in value in 12 years (72/6 = 12 years).

Likewise, the same principle can also be used to calculate the effect of inflation (increase in the cost of living) to halve the value of your money – e.g. if inflation is running at 3% per annum then your money will halve in real value (it’s purchasing power) in 24 years.

Why is this Principle important?

When planning your finances for the future you need to make a number of assumptions about how finances will change over time. Retiring today on £20,000 per annum pension may be comfortable for many people – but if you retire on £20,000 per annum in say 50 years time then the purchasing power of this income will be considerably less if the cost of living rises steadily over the next 50 years.

If you were to make an assumption that say inflation was to run at an average of 4% per annum then the real cost of living doubles every 18 years.

This is important for anyone planning to build a portfolio of assets over the longer term. In this example, consider someone age 29 – if we assume inflation of 4% per annum the cost of living will have quadrupled between now and retirement at age 65.

If the 29 year-old considers they can comfortable live on £25,000 if they retired today with all mortgages and other debts repaid by the time they retire, then by the time they reach 65, assuming 4% inflation, their portfolio will need to provide them with £100,000 per annum to maintain the same standard of living.

Needs and Wants – the Basics of Budgeting

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As with all topics, it’s best to start at the beginning with the simple steps first.

Sorting out Your Finances

In order to make decisions about what steps to take with the various aspects of your personal financial planning it is important to take a “snapshot” of where you are at at this moment in time.

A plan is just that – a plan – you decide on where it is you want to “arrive”, consider your current “position” , weigh up the various methods of getting there and choose the path which seems most appropriate to your current family situation, income profile, future employment prospects.

Where am I now?

There are three basic areas which you need to give serious consideration to which will help you formulate in your mind the starting point for your journey through your personal finances!

1. What do I OWN?
2. What do I OWE?
3. Who owes ME?

This will create a snapshot of your current “ME” position. In terms of what do I OWN – do you own your own house (what is its value?), what savings do I have? What investments do I currently have?

Basically, you need to consider all assets, either tangible or intangible.

Is a car an asset or liability? In one respect it is an asset as it allows you to travel to and from work, allows you to earn a living, saves you TIME not having to walk.

But in another respect it is a liability – you need to buy it, service the car loan, put fuel in it, maintain it, insure and tax it, then after several years and £1,000’s of depreciation you have to swap it in for a newer car.

After you have made a list of all your assets you need then to consider all your liabilities – just how much do you owe, how much is it costing to owe that money (interest rate) and is the amount you owe rising or falling over time?

Finally also consider all amounts owed to you – who owes you money? What is the prospect of it being repaid?! This money owed to you is an asset.

Finally consider all the “intangible” assets you own – these are not physical items like cars, jewellery, shares in companies etc. These are the skills, qualifications, knowledge, contacts and relationships – for many people when they are starting out in life these “intangibles” are considerably more valuable than the “tangibles”. In an ideal world, over time in order to build your wealth you need to follow this formula: –

“intangibles” + time = “tangibles”

4. How much cash is left over each month?

When you first start out on your wealth-building path you will generally start with very few “tangible” assets – you have skills, qualifications, drive and determination, perseverance etc. but you have very little in terms of assets – cash, investments, etc.

There are two main ways to increase your personal wealth – earn more than you spend and grow what you already own. Don’t count on inheritances as they may never come – the cost of residential care for the elderly will wipe out the majority of inheritances in the current economic and demographic climate.

Budgeting – Needs and Wants

Most people, us included, will have a set monthly income and expenditure. Have you actually analysed what you have coming in and going out each month?

It would be wise therefore to sit down and go through bank statements, bills etc and work out exactly just what you have coming in each month and what you spend it on.

The title of this article is “Needs and Wants” – all our expenditure can be split between being either a “need” or a “want”.

Accommodation – a “need” for all of us – as is food, clothing, water, heat and light.

“Wants” – these are all the other things – we may “want” the top package from our satellite TV provider – but do we “need” it?

The goal here is to identify all those items which you buy on a monthly basis which are “wants” and not “needs” – for every transaction simply ask yourself “Do we need this or do we want this?”

If it’s a “want” – ask yourself – should I spend my money on this “want” now which will give me some short-term pleasure or should I save the money so I can have more “wants” tomorrow????

This article links into the other article – “Pay Yourself First”

Please let me know what you think? Have you sat down and gone through and identified where you are wasting money each month – an increasingly important activity for many people with the “credit crunch” and current economic climate.

Term Assurance – an introduction

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Introduction

Term assurance is the most basic form of life assurance. As the name suggests, the policy runs for a fixed term.

There is no investment element to a term assurance policy – it is pure insurance – unless you make a death claim then the policy ends at the end of the term and you get nothing back.

Types of Term Assurance

Essentially there are three types of term assurance.

Term only – this provides cover for a fixed term, and if no claim is made, cover ends at the end of the term.

Convertible Term – this is a term assurance policy with a fixed term, but also included is the option to convert to “whole of life” assurance at any time during the plan. The conversion normally occurs without any further medical underwriting; assuming the same level of cover is applied for.

Renewable Term – again a fixed term contract, but with the option to renew a for a further identical term at maturity

How can they be set up?

It is possible to have single life and joint lives assured. So, for example, a husband and wife could take out two single life plans or a joint life, first death plan. With a joint life plan, on first death the proceeds from the policy are normally paid to the surviving life assured.

It is possible to take out two single life term plans, and write them under a suitable trust, for the benefit of spouse and/or children. The benefit writing a single life plan in Trust is that the proceeds from the policy do not enter your estate, where they could be delayed in being paid out, for example to redeem a loan or to provide for your children, due to the need to obtain probate which can take up to and sometimes in excess of 6 months.

We will cover more on Trusts and their uses in a later article.

When do they pay out?

As well as paying out on death of the life assured, modern plans may include “terminal illness” benefits – what this means is if you are diagnosed with an illness which, in the opinion of medical professionals, reduces your life expectancy below 12 months then the plan will pay out the sum assured ahead of your death.

The benefit of this is that you then have time to ensure the proceeds from the policy are used for the purpose which you intended and allow you to get your affairs in order ahead of your passing.

Cover Types

It is possible to set up plans in a number of ways: –

Level cover – the sum assured (amount of cover) remains constant throughout the term of the plan
Indexed cover – the level of cover increased each year, in line with a fixed percentage, to maintain the real purchasing power of the sum assured
Decreasing cover – often taken out at the same time as a repayment mortgage – the level of life cover decreases over time in line with the mortgage profile.

In the next part of this article we will consider the various options which can be included within a term assurance policy as well as the different uses and some special types of term assurance which are useful financial planning tools.

Inheritance Tax – allowances and reliefs

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In this second part of a three part series we will consider the main allowances and reliefs which can be used to reduce your liability to Inheritance Tax.

Nil Rate Band

This is the main relief which most people enjoy. The Nil Rate Band currently stands at £325,000  – on the first £325,000 of your net taxable estate IHT is payable at 0% – hence the name “Nil Rate Band”.

In the previous article we discussed that recent changes in legislation entitled a married couple to pass on any proportion of unused Nil Rate Band to the surviving spouse on first death.

(Please note – the Nil Rate Band has been updated for the 2009/2010 tax year which commenced on 6th April 2009 – Simon)

Inter-Spousal Exemption

Under this exemption, all transfers between spouses and civil partners, as long as they have a permanent home in the UK, are exempt from Inheritance Tax.

The exception to this rule is when a UK domiciled individual is married to a non-UK domiciled individual – in this case, any transfer from the UK domicile to the non-UK domicile receives IHT relief on the first £55,000 transferred only.

Exempt Gifts

Certain gifts are exempt from IHT, regardless of whether they are made during the donor’s lifetime or as a result of a gift through their Will on death: –

  • Gifts between husband, wife and civil partners
  • UK Charities – here is a list
  • Some national institutions such as museums, universities or into the National Trust
  • UK political parties

Annual Exemption

Any individual can make a gift of up to £3,000 in any tax year which is free from Inheritance Tax. Any unused relief can be carried forward for just one tax year.

Other Gifts

Some gifts made during lifetime are exempt from Inheritance Tax and they are detailed below:-

Gifts on marriage or entering a Civil Partnership

  • Parents can each give £5,000 cash or gifts
  • Grandparents and other relatives can give cash or gifts up to £2,500
  • Anyone else can give cash or gifts up to £1,000

Small Gifts Exemption

Any individual can make a gift during lifetime to any other individual up to £250 and not be liable to Inheritance Tax.

Gifts out of Normal Expenditure

Any regular gifts made out of net income (i.e. after tax has been paid) are free from Inheritance Tax. These can include regular gifts to someone – e.g. christmas presents, premiums on a life insurance policy or other regular or monthly payments to another person.

In order for this relief to work, the gift must be made out of normal expenditure and not be so high as to affect the donor’s standard of living in that they have to access their own capital to make good any shortfall in maintaining their standard of living.

Potentially Exempt Transfer – the Seven Year rule

Any gifts made to individuals will be exempt as long as there is a period of seven years between the date of the gift and the date of death.

If you die within seven years, and the value of the gifts exceeds the nil rate band, then IHT may be due on the gift. It would be the recipient’s responsibility to pay the IHT due on this gift.

If the value of the gifts is in excess of the Nil Rate band then “taper relief” may apply. HMRC give more information on taper relief here.

Gifts for Maintenance of the Family

Any lifetime gift for the maintenance of the spouse, child or a dependent relative may be exempt from tax as long as the gift is used for maintenance, education or training up to the age of 18, or to the end of full-time education if this is at a later date.

Other Reliefs – to be covered later

Other reliefs are available in respect of businesses, woodland, heritage and farmland – these reliefs will be covered in more depth at a later date.

Note

As with any issue relating to taxation, rules can and do change on a regular basis. Please ensure you take advice from a suitably qualified accountant or solicitor in respect of Inheritance Tax and the allowances and reliefs your own personal estate may enjoy.

Pay Yourself First – the first step in wealth creation

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One of the key principles of personal financial planning and wealth creation is to live within your means. This does not mean “going without” – it simply means to only buy what you can afford to buy.

Pay Yourself First

“Pay Yourself First” is a principle of wealth creation which I first came across in the fantastic book on wealth creation “The Richest Man in Babylon” by George S. Clayson and is a principle which has been repeated so many times through the ages.

Simply put, every time you receive any income, take a portion off the top BEFORE you spend any of the money on anything else and save it or do something constructive with it.

The book talks about taking 10%, but I feel in reality you should start small, say 5%, and allow your lifestyle to adjust to your new level of disposable income before increasing the amount you save. If done in small increments, the amounts you save each month will not feel as “painful” – you are less likely to miss another £10 per month taken from your income, than you are £100.

For example, if you earn £30,000 per annum, in the UK today you are taking home £1,800 per month after tax and national insurance contributions. 5% of this would amount to £90 per month. If you invested this £90 per month, and achieved a return of say 4% per annum, after tax and all charges, which would be conservative, then after 5 years you would have amassed £5,966.

Now let’s be honest, this £90 is not money which would have been spent on necessities but is money which would most likely would have been “wasted” on non-essentials. Here are some of what I consider to be the worst value items which people genuinely purchase on a regular basis:-

  • Per-packed sandwiches
  • Bottled water
  • Newspapers
  • TV listing guides
  • Gym memberships (and then stop attending after a few months!)

I am sure if you analyse your own expenditure you will identify those areas in which you “waste” money.

Repaying Debts – a form of “saving”

Alternatively, if you are currently carrying any debts, such as credit or store cards, consider redirecting this waster money into repaying those debts. With credit cards charging considerably high interest rates, by repaying these first you will be earning a far better return on your money.

For your Consideration!

Buy and read the book “Richest Man in Babylon” – it is an excellent read and is not an expensive purchase.

It is a worthwhile exercise to analyse your income and expenditure to see exactly where the money comes from and goes to each month.

Consider setting up a standing order from your current account into a savings account – many banks these days offer online “electronic savings” accounts, which pay a higher level of interest than your current account – simply set up a regular payment to take some money from your current account and place it in your savings account each and every month.

The other benefit of these types of account are that you don’t need to visit the branch – saving both time and money.

The best time for this payment to be made is just after payday!!!

We would appreciate your comments and experiences on this topic – feel free to comment below.

Inheritance Tax – an introduction

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In the first of a three part series we will consider Inheritance Tax – a tax previously deemed to be paid by “those who trust their heirs less than they trust the government”!

In part one we will consider what the tax is, how much is payable and the situation facing married couples.

What is Inheritance Tax?

Inheritance Tax is a tax payable on the value of your estate following death, and some gifts made within the 7 year period prior to your death – the tax is payable on the value of your net estate – all assets less all liabilities after certain reliefs and allowances have been made.

On what Assets is it Payable?

When considering Inheritance Tax we need to consider the domicile of the individual who has died. Domicile is a legal concept which explains a person’s true home and there are various factors affecting it. It is a complex legal subject which is beyond the scope of this article.

Generally, if you were born to UK parents, then that is your domicile and the liability to inheritance tax is payable on the value of ALL your assets, regardless of where in the world they are situated.

If you are non-UK domiciled, i.e. you moved to the UK recently, then liability to inheritance tax is calculated with reference to your UK assets only.

The tax is payable within 6 months of death and it is the duty of the Executors of your Estate to complete and file a probate form. If the tax is not paid within the 6 month window then interest will start to be charged on the amount outstanding.

How much is Payable?

Inheritance Tax is payable at the rate of 0% on the first £325,000 in the current 2009/10 tax year, with tax at a rate of 40% payable on the value of your estate in excess of this “nil rate band”.

So for example, if your net estate is valued at say £500,000 the liability to Inheritance Tax after your death would be £70,000 (£500,000 minus £325,000 at 40% taxation).

What about for Married Couples? Didn’t the rules change for them recently?

Fortunately, the law as it stands allows for all transfers between spouses to be made with no immediate liability to inheritance tax. In these circumstances Inheritance Tax is payable on second death.

There is an exception to this rule though, and that considers the situation where a domiciled individual is married to a non-domiciled individual. If the domiciled individual dies first, the transfer to the non-domiciled widow(er) is tax-free up to £55,000. Over £55,000 inheritance tax is payable.

Since October 2007, both married couples and registered civil partners have been able to raise the threshold on their joint estates on second death by effectively transferring any unused nil rate band (personal allowance) from the estate on first death to the estate on second death.

It is important to remember that on first death, the transfer of estate from the deceased to the widow(er) is exempt from Inheritance Tax, so 100% of their personal “nil rate band” allowance can be passed along for use on second death.

Also remember, it is the percentage of unused allowance, not the value of unused allowance that is passed on to the second estate.

For example, say John dies in 2008 leaving £500,000 to his wife, but also leaving £156,000 to his son. The transfer to his wife would be free of Inheritance Tax as it is an inter-spousal transfer, and the amount left to his son would also be free of Inheritance Tax as it falls within John’s nil rate band, which is £312,000 in that tax year.

In this example, John has used 50% of his nil rate band allowance and therefore, on second death, the estate can be reduced by applying 100% of John’s widows’ nil rate band PLUS 50% passed along following John’s death. So in effect, on second death, the estate benefits from 150% of whatever the Nil Rate band is at that time!

Inheritance Tax is a complicated subject and every person’s circumstances are different – it is vitally important that you take advice from a suitable qualified solicitor or accountant before putting in place any plans to reduce your inheritance tax liability.

In the next section, we will consider the various rates and allowances which can be used to reduce the Inheritance Tax bill. The final section will outline the various methods by which the Inheritance Tax liability can be mitigated.

State Pension – how much will YOU get?

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The State Pension is provided to those people who have made or been credited with sufficient National Insurance contributions during their working lives.

When do I get my State Pension?

State pension age is currently 65 for men and 60 for women, however, changes in legislation have been introduced to equalise retirement ages for both men and women to age 65 by 2020, increasing gradually from 2010. Women born between 6th April 1950 and 5th April 1955 will have a State pension age somewhere between 60 and 65.

Thankfully, the Pension Service have provided a State Pension Age Calculator on their website.

Will it Stop there Though?

No. In the UK we are suffering from the effects of an aging population. Todays pensions are paid out of todays National Insurance contributions. Over time the size of the working population will fall and the size of the retired population will rise.

Between 2024 and 2046,  State retirement age for both men and women will rise from 65 to 68.

How Many Years to Qualify?

Your National Insurance record needs to show the following level of service

  • 49 years for men
  • 44 years for women born on or before 5 October 1950
  • 45 years for women born between 6 October 1950 and 5 October 1951
  • 46 years for women born between 6 October 1951 and 5 October 1952
  • 47 years for women born between 6 October 1952 and 5 October 1953
  • 48 years for women born between 6 October 1953 and 5 October 1954
  • 49 years for women born on 6 October 1954 or later

    • How Much Will I Get?

    The actual amount differs from one person to the next – did you know you can request a State Pension Forecast – simply complete form BR19.

    How do I Claim my State Pension?

    You will normally be sent a letter 4 months before your State retirement date although you should contact them if you haven’t received a letter from them 3 months prior to retirement – you can claim over the phone 0800 731 7898 .

    Will I get Other Pension Benefits from the State?

    Again, depending on your own particular circumstances, you may qualify for additional pension in the form of SERPS or State Second Pension. The rules are complicated and it is beyond the scope of this article to discuss SERPS and SSP in any great detail.

    What Action Should I Take Today?

    It would be prudent to work out your State pension date to allow you to plan your income and expenditure in the lead up to retirement – use this calculator.

    More importantly, you would be wise to ask the Pension Service for a State Pension Forecast – simply fill out and send off their form BR19 (1.17MB) or call them at the Future Pension Centre on 0845 300 0168 . If you are hard of hearing or have speech difficulties they also offer a Textphone facility – 0845 3000 169.

    We will discuss SERPS, Second State Pension etc in more detail at a later date.

    ISA’s – Individual Savings Accounts

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    As we approach the end of another tax year on 5th April many will be mindful of the need to fully utilise their ISA allowance –  you may have heard people mention ISA’s but you’re not quite sure what they’re all about – something tells you they’re risky!

    What is an ISA?

    An ISA (Individual Savings Account) is a form of tax-efficient savings and investment product. Following recent changes in legislation there are now two types of ISA with which we are concerned: –

    Cash ISA

    A Cash ISA is a savings account, normally through a bank or building society, as well as National Savings, which effectively pays interest tax-free. Cash ISA’s are available to anyone over the age of 16.

    With a normal savings/deposit account tax is deducted from gross interest and the saver receives the net amount – the current rate of tax on interest is 20%. There is no additional tax to pay for a basic-rate tax payer; a higher rate tax payer will pay an additional 20%.

    With a Cash ISA though, anyone, regardless of their tax position, can invest up to £3,600 in the current tax-year to benefit from tax-free interest. The government place a limit on the amount you can invest in your ISA due to the tax-efficient nature of the investment.

    Non-taxpayers – did you know?

    If you are a non-taxpayer you can register to receive your interest on your bank and building society accounts gross – you need to fill in form R85 – getting your interest without tax taken off – simply complete the form for each account/institution and pass to them to amend their records.

    Where can I find the best rate?

    League tables are generally published in the better quality newspapers, or alternatively you can search on line at a comparison site, such as moneyfacts or any other cash ISA comparison site.

    Are they instant access?

    Generally, yes, but a number of products offer a higher rate of interest, or even a fixed rate, in exchange for you not making any or many withdrawals – you can normally access your money though with an interest penalty applying. Make sure you check the terms and conditions for any cash ISA you choose to invest in.

    Stocks and Shares ISA’s

    These are for the more adventurous investor. The overall allowance for investing in ISA’s is currently £7,200 per person per tax year. Any investment made into a cash ISA in the current tax year will count against this allowance. For example – say you have put £2,000 into a cash ISA, you are therefore able to invest an additional £5,200 into a stocks and shares ISA.

    Lump Sum or Regular Contribution?

    It is possible to set up both single premium and regular monthly ISA’s. If you go for the regular option this would equate to £600 per month if you spread your allowance across the full tax year.

    Where can I invest?

    There is an enormous choice of places to invest your Stocks and Shares ISA allowance – you could choose to invest direct into the shares of a few companies, or you could reduce the risk slightly by investing in “pooled fund(s)”.

    By investing in a pooled fund, the investment manager pools your money together with the money of all the other investors in the fund, and invests the money by buying and selling shares and other assets in line with their management style. The benefit of this is that the investment manager and their team can use their investment expertise and research to invest in companies they believe are going to provide an above average return going forwards. The second benefit is that your money, through a pooled fund, will be spread over a far wider range of companies – therefore reducing the risk to your money.

    You can invest either direct with a fund manager or through a “fund supermarket” – the latter option will give you access to a large choice of different funds from a wide choice of investment managers. Fund supermarkets can sometime negotiate discounts on the charges and pass these savings on to their clients.

    Charges?

    Yes – normally with a pooled investment there will typically be an “initial charge” which can be from 0% upwards with initial charges typically being in the region of 5%. There might also be an “annual management charge” – this covers the ongoing costs of running the investment fund. These AMC’s are typically in the region of 1% – 2% per annum – check the charges on any fund you choose to invest in prior to committing your funds.

    Is there a risk?

    Your money is being invested in a fund(s) which the manager will invest in a range of stocks and shares of companies, corporate bonds, gilts etc depending on the investment strategy and type of fund you choose.

    I am sure you will be aware of the recent falls in world stock markets. Any fall in stock markets will be reflected in the value of your investment – so yes, you could lose some, or even possibly, all of your money. For this reason you need to ask yourself whether you are prepared to take risks with this money – and also to give consideration to the length of time you are willing to invest for – a minimum of 5 years, and preferably 10 years would be a good answer here!

    Why invest in ISA’s?

    The benefit of ISA’s is that they grow in a very tax-efficient manner and any income you receive from your ISA is also tax-free. In addition to this it is also possible to access the money invested if the need should arise.

    Many people use their ISA allowance to save and invest for longer term goals – such as a house move in 5 or 10 years time, or to provide income in retirement, to supplement other pension income – some people prefer to invest in ISA’s than in personal pension plans due to the fact that they can access their ISA money – although that can be too much of a temptation to some people!

    Summary

    There are two different types of ISA and you can invest up to £7,200 in the current tax year. Once we pass 5th April you will lost your ISA allowance for the current tax year – once gone it is lost forever.

    Risk Warning

    With a stocks and shares ISA there is risk to your capital – the value of your investment is not guaranteed, the value of the investment, and the income from it, can fall as well as rise. You could lose some or all of your money.

    If you have any comments to make on ISA’s please add them below –