Compound Interest, The 8th Wonder Of The World!

Published: Thu, 11/07/13

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Financial Tips

Helping Dentists & Doctors Achieve Their Most Important Goals

0191 217 3340

Welcome to Financial Tips!

Published every 4 weeks by Rutherford Wilkinson Ltd,
written by Financial Planners Ray Prince and Graeme Urwin.

Approximate time to read: 7 minutes

In This Week's Issue:

Feature Article: Compound Interest, The 8th Wonder Of The World!
Hot Topics Q & A: Inheritance Tax - How Can It Be Avoided?
Wrap-Up (Ray)

Compound Interest, The 8th Wonder Of The World!

Wikipedia describes compound interest as:

Compound interest arises when interest is added to the principal of a deposit or loan, so that, from that moment on, the interest that has been added also earns interest. This addition of interest to the principal is called compounding.

A bank account, for example, may have its interest compounded every year: in this case, an account with $1000 initial principal and 20% interest per year would have a balance of $1200 at the end of the first year, $1440 at the end of the second year, and so on.

And it was Albert Einstein who said:

"Compound interest is the eighth wonder of the world. He who understands it, earns it...he who doesn't...pays it."

Let's look at some numbers so we can see compound growth in action.

If I were to ask you which option you'd prefer, how would you (honestly) answer:

1. 1p that doubles every day for a month

2. £1m cash in your bank account immediately

Now, you may be thinking that this is obviously a leading question and you'd be correct! But I'm guessing if the question was asked out of the blue many would opt for 2.

In fact, option 1 would return in excess of £10m!

The power of compound interest at work.

I'll admit that it's unreasonable to expect a 100% return on any investment every single day, however it's the principle that I want to concentrate on.

In effect, all interest earned on any investment is effectively free money and interest earned on interest is the holy grail.

The 3 Rules

The amount of money you'll get back on any investment is determined by:

1. The amount you invest

2. The length of time your money is invested for

3. The rate your money grows at

Back to some numbers.

Let's say you have a target of £300,000 at age 60.

Age 30 40 50

Years to 60 30 20 10

Growth Rate 5% 5% 5%

Monthly Payment £366 £736 £1936

Total Invested £131,760 £176,640 £232,320

So as you can see, the longer you leave it the more it'll cost over the long term.

Looking at another example, let's say you invested the £366 per month between the ages of 30 and 40 but then stopped.

Here's how the numbers look:

Age 30 40 50

Years to 60 30 20 10

Growth Rate 5% 5% 5%

Monthly Payment £366 £369 £971

Total Invested £43,920 £88,560 £116,520

Maturity Amount £150,513 £150,513 £150,513

As you can see, the 'cost of delay' is stark, so if you can afford to invest more at an earlier age you'll save a hefty sum, all factors being equal.

So, time indeed can be your friend when investing

Looking at rule 3, how do the numbers look if the return is 7% pa? (remember, the target is £300,000)

Age 30 40 50

Years to 60 30 20 10

Growth Rate 7% 7% 7%

Monthly Payment £255 £588 £1744

Total Invested £91,800 £141,120 £209,280

As you can see, there's not a huge saving if you start investing at 50 (10%), however it's a different story at age 30 where you'd save 30%!

And what about the cost of delay example at 7% pa where you invest the £255 per month between the ages of 30 and 40 but then stop?

Age 30 40 50

Years to 60 30 20 10

Growth Rate 7% 7% 7%

Monthly Payment £255 £333 £987

Total Invested £30,600 £79,920 £118,440

Maturity Amount £169,738 £169,738 £169,738

You get the point, I'm sure.

Whilst there are a number of factors you should take into account before you invest, some of the key ones are (in no particular order):

Inflation
Investment fees
Transaction fees
Adviser fees (if you use one)
Product fees
Tax

The Financial Tips Bottom Line

It's not always easy to invest the amounts you want when you have other commitments, however by budgeting and being more aware of where you're spending your money it's possible to find additional sums each month.

Action Point

If you do want to analyse where your money goes each month, the tool we recommend is You Need A Budget.

After all, if you're able to invest another £100-£200 each month you'll be able to (potentially) enjoy the benefits of the 8th wonder of the world!

Hot Topics Q&A: Inheritance Tax - How Can It Be Avoided?

Every week we receive questions from clients regarding all aspects of their financial planning. So, rather than keep the answers to ourselves (and clients) we publish one key topic each issue.

Q. We're aware that our estate could be liable to Inheritance Tax on our deaths. We've not done any planning yet as we're uncertain what we should be doing.

Can you give us some pointers in the right direction please?

A. HM Revenue and Customs (HMRC) receipts from Inheritance Tax (IHT) are on the increase again. In 2011/12, the Treasury took £2.91 billion compared with £2.72 billion in 2010/11.

The number of estates that paid IHT also increased by 3,000 to 20,000. More people are therefore interested in inheritance tax planning.

The current rules mean that a deceased's estate will be liable at 40% on all chargeable assets that exceed the nil rate band - currently £325,000. Chargeable transfers made within the last 7 years are taken into account for this purpose.

In 2008/09 and 2009/10 IHT receipts had reduced due, in the main, to the economic recession, meaning that asset values had reduced; and the introduction of the transferable nil rate band, meaning that if the first spouse to die did not use all of their nil rate band the unused amount (expressed in percentage terms) could be transferred to the surviving spouse.

These two factors have now "bedded-in" to the statistics on tax receipts. Furthermore, despite the Chancellor previously announcing that the nil rate band would increase to £329,000 in 2015/16, it will now be frozen at £325,000 until 2017/18 to help finance the increased cost of social care.

All the signs are therefore that the impact of IHT will get much fiercer. Given that IHT will inevitably impact on more families, we believe that there will be more enthusiasm from clients to hear about IHT-effective planning and strategies.

Whilst IHT is one of the taxes that the new General Anti-Abuse Rules (GAAR) can apply to, it seems very unlikely that HMRC would seek to apply them to the tried and tested IHT planning techniques that are frequently used in the personal financial planning sector.

So, in brief, what action should you consider in planning for IHT?

Here is a very quick overview of the key planning points:

You should make a Will so you can be sure where your assets will go on your death. If you're married or in a civil partnership, thought should be given as to whether the nil rate band of the first to die should be used on the first death or use made of the transferable nil rate band. Given that the nil rate band is frozen until 2017/18 more people are now making use of their nil rate band on the first death as growth on investments gifted is then outside the estate of the survivor.

Make regular lifetime gifts and so use the annual exemption and (if possible) the normal expenditure out of income exemption.

Consider bigger gifts. Outright gifts will be potentially exempt transfers (PETs) and so will not attract any IHT provided the donor survives for 7 years. Take into account any capital gains tax (CGT) that could arise on the gift.

If ongoing control of the asset gifted is required, consider using a discretionary trust. Don't exceed your available nil rate band as otherwise lifetime IHT will be payable. If CGT is likely to arise, consider whether a claim for CGT hold-over relief can be made, this will depend on the beneficiaries under the trust. The advantages of a discretionary trust are that the donor (the settlor) can, as a trustee, have some control over the investments of the trust and so determine who will benefit and when. However, the settlor cannot be a beneficiary and so cannot receive any income/capital as otherwise the gift with reservation rules will apply.

Fortunately, certain schemes have existed for a long time that can provide the settlor with the ability to place a lump sum in trust yet enjoy an "income" (or more precisely a stream of capital payments). HMRC has confirmed that these plans will not be subject to the gift with reservation rules or the pre- owned assets tax (POAT) rules.

If life expectancy is less than 7 years, a lifetime gift will not be so appropriate. Instead, provided you have the right investment perspective, an investment into an Enterprise Investment Scheme (EIS) that invests in a basket of shares may be appropriate. Here, once the investments have been owned for 2 years they will be outside the investor's estate for IHT purposes. Furthermore, the investor should qualify for income tax relief at 30% on the investment.

If you own business assets, such as shares in a private limited company, any planning should aim to maximise the use of business property relief. Thought should be given to gifting such assets either directly to children or into trusts for children on your death to utilise the generous 100% level of business property relief that is currently available.

Where you are a member of a pension scheme under which you have substantial death benefits, if those benefits are paid to the surviving spouse that payment will add to any IHT problem on that spouse's subsequent death. In such cases, consider the merits of a by-pass trust as a vehicle to receive the lump sum death benefits and give ongoing wealth protection and IHT protection for the family yet still ensure that the widow/widower can benefit.

Planning may be more difficult for those who face a substantial potential inheritance tax liability because they own assets that, by their nature, are difficult to gift, for example a private residence. In this instance you could consider "covering" the liability by effecting a joint lives last survivor life assurance policy in trust for the beneficiaries who will suffer because of the tax liability. This will mean that such people will have cash to meet the tax liability and this will preserve the assets in the estate.

In summary, by being proactive it's posible to ensure that any tax is minimal for your beneficiaries.

Please send us your questions! It's easy to do. Just send an email to us here (and if we publish it we'll make it anonymous).

Wrap-Up - The Family Wagon & Dental Goodwill

Well here we are fast approaching the end of the year.

On the personal front I finally succumbed to the fact that I have a growing family (2 girls) and purchased a new car at the end of September!

My father-in-law is a bit of a car buff and heard that Vauxhall were offering a deal on the Zafira.

And with capability for 7 seats it's ideal for those big family outings (woo hoo!).

I've never been a fan of buying new cars due to thedepreciation over the first 12-24 months, however this deal turned out to be one that couldn't be ignored.

I have to say I think we played a great double act at the dealers with my father-in-law playing the lead role.

At the end of the 2-3 hours we were there we managed to get a £20k new car for £9500

During September Graeme and I were in London for a business and personal development conference, held at Kings Place next to King's Cross train station.

The venue was fantastic and it's fair to say that the area around King's Cross has gone through an incredible transformation during the last decade or so.

In fact, Boris was there on the day to formally open the front of King's Cross station where the old frontage has been restored.

Onto other matters, NASDAL released their latest Dental Goodwill survey results during September, looking at the period April - July.

It shows that NHS practices had, on average, goodwill value expressed as a percentage of gross fee income of 105.2%.

When valuations versus actual sale figures are analysed it indicates that NHS practices can attain more than expected, whilst private practices go for less than expected. Mixed practices are more predictable.

Alan Suggett, a specialist dental accountant of UNW LLP commented: "My thoughts about the survey are that it continues to show that NHS practices are highly sought after, with smaller ones being sold with goodwill valued on a percentage of fee income basis (usually around 100%), and larger ones on an EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation) basis, which can yield much more."

A key aspect in the differentiation is that large NHS and mixed practices are of interest to corporate buyers which are competing with each other.

The figures can't be taken in isolation, Alan stressed, since large corporate purchasers usually insert performance criteria into their buying price.

So, whilst they may be ready to pay above "market rate" for a practice, but if in the years following the sale the practice doesn't perform in line with pre set expectations, then the sale price is reduced. He added: "We are therefore measuring a maximum sale figure which, in the course of time, could be reduced."

If you'd like to discuss any aspects of this with Alan you can contact him here or on 0191 243 6009.

See you next time.

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