'How can we cut our £500k inheritance tax bill?'

Hakim is 68 and Noura is 65. The couple are income-rich with multiple sources, and have significant cash savings. However, they face a huge inheritance tax (IHT) bill and are looking for ways to cut this down.

Having spent their careers as doctors, they faced a tricky situation with the pensions lifetime allowance, but the chancellor came to their rescue in this year's Budget. However, they need to review the investment strategy of their portfolio of individual savings accounts (Isas) and pensions. 

The couple have largely retired but Hakim does occasional locum work and Noura works one day a week. However, they plan to stop doing this around the end of this year. Income-wise, they receive more than they spend despite holidaying six to eight times a year.

He receives a defined-benefit (DB) pension of £35,000 a year and almost the full state pension. Noura's DB pension pays £32,000 a year and she will soon receive a state pension of £7,000 a year. They also have three mortgage-free rental properties, worth £230,000, £170,000 and £320,000, which provide another £35,000 a year. And they receive dividends of around £12,000 a year from venture capital trusts (VCTs).

Hakim and Noura’s home is worth about £450,000 and they have a holiday home in Dubai worth about £250,000, both of which are mortgage-free. They have three financially independent children who have already been gifted houses, which they hope will be covered by the seven-year IHT exemption.

"Our income more than covers our annual expenses," says Hakim. "This means that we have not needed to draw from our investments. Two years ago, we gave three mortgage-free properties worth between £170,000 and £260,000 to our children, and hope that we will live for another five years so that this transfer is not liable for IHT. But we wondered how else we could mitigate IHT?

“How should we run down our Isas and self-invested personal pensions (Sipp)? We have been investing for about 30 years and are aiming for growth. I would say that we have a high risk appetite, given our guaranteed pension income, and could tolerate the value of our investments falling by up to 25 per cent in any given year.

"Are our investments well allocated across different sectors and regions, or are they too diversified – especially as I have recently started to add tracker funds?"

NONE OF THE COMMENTARY BELOW SHOULD BE REGARDED AS ADVICE. IT IS GENERAL INFORMATION BASED ON A SNAPSHOT OF THESE INVESTORS' CIRCUMSTANCES.

Doug Brodie, managing director of Chancery Lane Retirement Income Planning, says:

This portfolio appears to have been set up to address tax with investment returns a secondary consideration. This is very common with self-select portfolios because tax criteria are absolute and tend to be finite – you decide on one course of action and then leave it alone. But investing is a multifaceted art, no one portfolio is correct and not everyone agrees on your choice.

You hold too much cash – either give it away to your kids or invest it for income. Neither of your guaranteed pension incomes push you into the higher-rate tax band so you need to plan carefully how to allocate the buy-to-let income. Using the cash to offset any higher-rate tax by investing in more VCTs is an obvious answer, but I’m uneasy with the amount you already have in VCTs. If you only have a downside risk tolerance of up to 25 per cent, your allocation to VCTs is too high. Don’t be seduced by the tax-free dividends – in many cases that’s just your capital being handed back to you.

Noura has a substantial portion of her Isa in high-risk assets, including Baillie Gifford-managed Scottish Mortgage Investment Trust (SMT) and Baillie Gifford American (GB0006061963), and your holdings in these were down 38 and 37 per cent, respectively, at the time you submitted your details to the Portfolio Clinic. Cut at least half your losses. The US exposure is compounded by Hakim's exposure within his Isa to a dollar-denominated index via Vanguard US Equity Index (GB00B5B71Q71). This fund has around a quarter of its assets in technology and, as of the end of May, NVIDIA (US:NVDA), which is valued at 37 times its total revenue, alone accounted for 2.27 per cent of the fund's assets.

As you are 68, you need to protect your family’s capital as you don’t have income to replace it. That’s not hard to do, but first of all you and Noura need to agree on a core objective, and only invest in assets intended to deliver that. This will enable you to select investments only with reference to that objective and then measure them against it.

You have many assets and no debt, and are happy with the income you get from your inflation-linked pensions. If you need further income, a steady portfolio of investment trusts such as City of London Investment Trust (CTY), Lowland Investment Company (LWI) and Murray Income Trust (MUT) would help to protect your capital and allow you to spend money, for example on holidays and not worry about how to fund them – as you would have reliable and regular income.

You could hold an income portfolio within your Isas and clear out everything else. If you don't need that tax-free income, you could give it to your kids using the gifts from excess income IHT exemption, but make sure you comply with HM Revenue & Customs rules.

The Sipps can be passed on IHT-free: if you don’t need the income, take the tax-free cash from them now and give that money to your children. Then sell all the holdings in the Sipps and reinvest the proceeds in an MSCI World Index tracker fund and leave it alone as, in effect, it’s no longer your money but rather your kids' money in 30 years’ time. It's the type of thing that high-profile US investor Warren Buffett would do.

You have an IHT liability as you own property which is not your main home worth almost £1mn. Your estate is currently worth around £2.4mn and around £1.4mn of it is liable to IHT, so a potential tax bill of £560,000. This large liability means that it is worth getting professional advice on this. However it’s put together, there are generally only two solutions to IHT – either spend your assets or give them away, so your family might also have some input on what to do about this.

Peter Doherty, head of investment research at Arbuthnot, says:

Congratulations on your retirement. It looks as though you are very well provided for through all your income sources, which also offer a degree of inflation protection.

Starting with your high cash balance of £645,000 (around 20 per cent of your total assets), I would consider what would be the right cash level for emergencies and seek advice on whether the excess cash should be invested or used for IHT planning. Currently, your cash is exposed to higher income tax bands on interest earned and potential inflation erosion.

I do not think trackers are overly diversified. They are a simple, low-cost way to gain access to broad markets, without worrying about an active fund manager’s performance or single stocks, thus making them easier for you to track. The downside is you will not outperform benchmark indices and still need to select the regions or sectors you want to allocate to. Overall, the investment mix looks in line with a high-risk appetite and growth focus, being almost exclusively allocated to equities. You are well diversified from the perspective of any individual stock being a concern, so it is more systemic risks (global crises of some sort) that will impact your portfolios.

One thing that does does need attention is your allocation to UK stocks over other regions, at around 46 per cent of your combined portfolio, which brings with it performance biases. And you have only 33 per cent allocated to arguably one of the most attractive markets in the world on many metrics (aside from its perpetual premium valuation), the US.

The result of this skew would have caused drawdowns in 2020 and 2022 that surpassed your 25 per cent limit, although only temporarily. I have a few ideas that also address the diversification questions you posed and could limit the amount by which the value of your portfolio falls.

Sterling is a cyclical currency when compared to the likes of the US dollar or Japanese yen. Thus, in times of stress, the pound tends to fall. A greater allocation to non-sterling 'currencies via US or Japanese assets should provide a nice offset when your stocks fall in periods of stress. Currency diversification is a highly underestimated tool that is often overlooked.

To retain the ‘value’ orientation of your current exposure, while gaining currency diversification, consider a global value exchange traded fund (ETF), which should create a downside buffer when equity markets fall, due to better currency diversification.

From a sector perspective, your relatively low weighting to the US creates an underweight to technology and consumer services. Companies in this sector in the US, while generally more expensive, have arguably better long-term growth potential, and you may wish to consider adding more to this sector via an active fund manager or simply through a Nasdaq or S&P 500 ETF. 

Altogether this should lead to a similar expected long-term return while gaining improved diversification to manage potential losses in periods of stress and a smoother ride while you enjoy your retirement.