Enlist tax rules to retire comfortably

money makeover

Names: George and Patricia Grimes

Ages: 63 and 60

Occupations: Retired lecturer and NHS nurse

The problem: George and Patricia will have combined pension incomes of about pounds 20,700 when they have both retired, enough to cover their current outgoings of around pounds 13,000 a year. They also own their home free of mortgage and have a portfolio of shares and other investments worth about pounds 70,000.

Altogether their net worth is about pounds 220,000, of which about 60 per cent is the value of their property. The total does not include the value of cars, caravan and other possessions.

They would like to see if they can generate more income to supplement their pensions.

The adviser: Frank Klonowski is a graduate in theology who spent 12 years in catering management before becoming a consultant with Legal & General in 1988. Five years later he set up his own financial planning business based in Leeds, telephone 0113 273 5255.

The advice: If we apply this year's personal allowances and today's tax rates to next year's projected income - when both pensions are payable - their net [after tax] income would be pounds 10,568 and pounds 7,752 respectively.

Each has an annual personal allowance, ie the amount of income allowed before tax becomes payable. This is currently pounds 4,045, but in the next tax year George becomes entitled to the "additional age allowance" - which increases his personal allowance to pounds 5,220. He should be entitled to this for the whole of the next tax year as he attains 65 during the year.

But this additional allowance is only available where total income is below a certain level - currently pounds 15,600. For every pounds 2 over this level, he would lose pounds 1 of the extra allowance until he reaches the level of the normal personal allowance - an effective tax rate of 34.5 per cent on this portion of income. This is known as the "age allowance trap".

Great care must therefore be taken when adding extra income to their respective pensions. It is usually more tax efficient to create extra income by investing in tax-free instruments like PEPs and Tessas or encashing the gains on investments, rather than simply choosing income- producing investments which are taxable.

George and Patricia each have an annual capital gains tax allowance, currently pounds 6,500; this can in effectmean an extra pounds 13,000 a year tax free.

Assuming reasonable growth in dividends and capital the maximum that George and Patricia could take from their portfolio to ensure that they do not run out of money too early would be just under pounds 6,500.

They should keep at least pounds 5,000 on deposit to meet immediate needs. After that they should look for tax-free income. Their existing holdings of investment bonds have several advantages. Under present legislation on it is possible to withdraw up to 5 per cent of the original invested amount each year with no immediate tax liability; this is a cumulative figure, and may therefore be carried forward to subsequent years.

Importantly, this withdrawal facility doesn't at present affect the age allowance.

They should split the unit trusts equally between them - this gives more flexibility in using their capital gains tax exemptions. Next, they should utilise their general PEP allowances for the 1997/98 tax year. Patricia already contributes pounds 50 per month to a PEP and has done so since April - this means a further pounds 5,400 may be paid, but the choice is limited to the one in which she now saves. She should suspend her direct debit at the end of March to ensure no payments are made in the next tax year - even one monthly payment would mean only being able to invest in that same PEP.

They could buy more PEPs by exchanging up to pounds 11,400 of their current investments, beginning with the remaining individual shares, then moving on to the two unit trusts.

Next, they should increase their cash base by putting pounds 3,000 into a Tessa for George and pounds 9,000 into index-linked savings certificates for further tax-free interest. Although this involves leaving them for five years, we have already seen there is sufficient liquidity elsewhere in the, portfolio to cover this period.

George and Patricia also need to consider the possible need to pay for long-term care With full nursing home costs in the provinces estimated at pounds 17,000 a year, the drain on resources may be quite severe.

I understand they have up-to-date "mirror" wills which leave everything to each other, then to their three children. The present inheritance tax liability for their children is pounds 6,680.

George and Patricia may not be able to use their annual exemptions by making gifts to their children, as they will rely on their total portfolio for income. However, they should consider using a Deed of Variation, which enables the terms of a will to be varied within two years of death.

The survivor could then, if necessary, redirect some of the capital to the children. This would at least use up part of the deceased's nil- rate band which would otherwise be wasted.