School fees, tax & retirement: challenges of the ‘squeezed middle’

Louis Coke, Senior Investment Manager tells the story of his friend Jeff, who is in the ‘squeezed middle’, and reveals financial tips to help in this situation.

| 9 min read

Let me tell you about Jeff. In some ways Jeff is the vision of what many people would define as successful, and with that comes the assumption that he probably has very few issues in life. Jeff has a highly paid job in in professional services, he is married, has two young children and a mortgage. He lives in the South East of England and is in his late 40’s. What’s not to like?

Where Jeff’s story gets a little more complicated is, like many of us, when you scratch beneath the surface.

Challenges of the squeezed middle

Despite his high level of income, one frustration Jeff has is that he seems to lose most of his income either to taxes, education for his children and more latterly, increasing mortgage costs. He certainly doesn’t begrudge paying for these things, but niggling away at the back of Jeff’s mind is the feeling that he is on a treadmill, running ever faster, with no visible way to get off.

Jeff’s ideal ‘off ramp’ would be in the form of some kind of retirement plan or roadmap, but a couple of things prevent him from making significant strides to get there. First of all, even if he could spare the funds to aggressively save into a pension, the UK’s tapered annual allowance rules restrict him from doing so. Secondly, cash flow is already surprisingly tight given the tax and other expenditures Jeff has to account for, so what does he do?

This is a situation that a surprising number of people find themselves in. It may sound unlikely for people earning several hundred thousand pounds or more per year, but I assure you it happens. Aside from the financial frustrations, this can also cause issues around morale and motivation, and quite often people who fall into this situation are ‘high performers’ in their industry or firm, with their remuneration tied to their individual performance at work.

On the face of it, one might be forgiven for thinking that there is not much that can be done- taxes are what they are, mortgages must be paid and education costs are a choice that are specific to your own family views and dynamic. But is it really that simple? Does Jeff have to just accept that outcome?

Financial tips for the squeezed middle

There are actually several ways in which Jeff could think differently about his situation and how to move away from this ‘treadmill’ feeling. Below, I share some thoughts on the benefits of seeking advice and the power of what that could potentially achieve in Jeff’s case.

Jeff’s default way of looking at his financial life is to look at it in isolation. In his eyes he is the breadwinner of the family and so the financial responsibility rests on his shoulders. But what Jeff is not necessarily looking at is his aggregate family wealth, which is potentially where some opportunities can present themselves.

Find smart ways to deal with school fees

Take school fees, for example. This is long term expenditure and is a significant amount over several years. Jeff is paying this out of his net earned income and accrued savings. What if there were a smarter way?

By speaking to his parents Jeff might realise that their financial situation is rather different to his own, with their mortgage long since paid off, final salary pensions giving ample income and savings and investments giving them a solid capital base. What if Jeff’s parents paid the school fees, and adjusted their Will such that this was accounted for in any eventual distributions from their estate?

That potentially achieves two things- firstly it relieves Jeff from the worry and financial obligation of making payments each term. Secondly, his parents feel like they are actively making a difference to their grandchildren’s education. Third, if structured correctly the school fee payments may actually reduce the amount of inheritance tax due on Jeff’s parents’ estate when they pass away.

One common theme I notice in looking after family wealth is that the younger generations can sometimes have a need for funds far before they receive anything in the form of ‘post death’ inheritance. Lifetime gifting can, if used correctly, greatly assist family members at the time when it is needed most.

Optimise your retirement savings

    Next, we can look at Jeff’s pension provision. The UK tapered annual allowance rules have been in place for some time and the basic rule of thumb is that as income increases above a certain threshold, the amount an individual can put into a pension and gain tax relief is reduced. Jeff now has some capital to invest as he is no longer paying school fees, but where does he put it?

    Quite often when people think about saving for retirement, they think about pensions. That makes sense for the majority of people but for very high earners, it can be beneficial to think about cash flow, rather than pensions. In effect they are the same thing, but the tax wrapper(s) used to deliver funds in retirement can be very different.

    In this case, Jeff might want to first think about using his and his wife’s annual ISA allowances. This does not give tax relief on contributions, but gains and income generated within the ISA are free of UK income and capital gains tax, and funds can be withdrawn at any time. This means that as any growth does not incur tax, it can compound faster. There is also the straightforward option of simply investing funds in Jeff’s own name, or jointly with his wife for (taxable) gains and income over time. If Jeff found himself earning significantly more as the years roll on, more complex planning might be beneficial, for example using investment bonds to manage the timing of taxes that are due.

    Choosing the right investments is also a key consideration. Does Jeff take a high risk, high reward approach, in an effort to grow his wealth as quickly as possible? Or does he invest cautiously, leaving the ‘risk’ part of his financial life more associated with his ‘career’ risk taking? Having put in significant effort to generate this capital, making sure this last part of the process is carried out in line with his wishes, attitude to risk and with due care and attention is absolutely vital. Over recent years we have seen multiple up and down swings in markets, with the potential to destroy wealth just as much as to create it.

    Is your mortgage working for you?

      Another of Jeff’s frustrations was around his mortgage and the rising cost of repayments, largely due to the increase in interest rates we have seen of late. With school fees now being funded by his parents, Jeff might consider overpaying on his mortgage to reduce the interest liability over time, or perhaps having an offset mortgage if his provider allows it. This can have the effect of reducing his regular costs and therefore freeing up capital for other purposes.

      Consider tax-efficient investments

        Finally we come to tax. As an employee there is little Jeff can do to change the way he is paid or the quantum. However, depending on Jeff’s attitude to risk taking and locking funds up for the long term, he might be interested in the UK’s EIS and VCT investing schemes.

        Broadly speaking these can provide investors with income and capital gains tax reliefs in exchange for providing ‘risk capital’ to small UK businesses. The end result would be that if all goes well, Jeff’s effective tax rate would drop and he has the ability to generate a profit on the investments he makes. The downsides are that capital is invested for a period of time (typically 3-5 years) with little option for selling if he changes his mind.

        Investing in small businesses can also be risky and so Jeff would need to understand that the tax relief is there for a reason- risk capital mean exactly that, there is a risk of losing his investment.

        A final note

        The thoughts mentioned here are not meant as advice, but rather to show the power of receiving advice. The points here are also not exhaustive – different people require different approaches to achieving their goals and tax rules and planning opportunities change over time. There can be distinct benefits in looking at wealth as a family unit, being clear with your goals and frustrations and having advisers on your side that understand these challenges.

        I hope the points raised here are thought provoking and if you or someone you know are in the squeezed middle like our friend Jeff, a conversation may be beneficial.

        Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

        School fees, tax & retirement: challenges of the ‘squeezed middle’

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