Venture Capitalist Trusts are a risky but possibly rewarding investment class. In this third post, I’ll demonstrate how they may be used to glide into Early Retirement using a bit of planning and foresight.
In Part 1, I covered the basics of what VCTs are and in Part 2, I talked about how to buy, hold and sell VCTs. If you are still interested then this post will give you an idea of how you can get VCTs to work for you and how they can be used to aid early retirement.
How VCTs can be used for Financial Independence and Early Retirement
First of all, I’m going to be making a few assumptions about the person investing, their financial position and aspirations. I’m guessing that if you are thinking of financial independence, you’ve managed to sort out your spending to make sure you live beneath your means – this could be saving money from your job. That money that is saved starts to build up, so you are starting to think of where to put it and you’ve maybe got an assortment of ISAs, LISAs, SIPPs, Pensions, premium bonds, stocks, shares, cash ISAs and a 1/40th share in a racehorse that you thought was a good idea but he eats more hay than he wins in prize money.
Anyway, if you’ve got these savings you have a bit of flexibility on how you spend/invest your money and the freedom that that brings you. At this point there’s no such thing as an out of the blue bill and you are able to put money away without needing it tomorrow. I’m also going to assume that you don’t see FIRE as a quick fix, and are committed to the long run.
You are also acquainted with the tax man and he considers you a good friend. You might be seeing 40% of your marginal income going to him (or more). You might even be in the privileged position of paying more in tax than you spend on yourself! So, my guess is that you are earning well, spending less, saving hard and investing wisely.
Sequence of Returns Risk (SORR)
Many early retirement plans sound like this “get to FI number, quit job, burn bridges, live off 4% a year forever, the end. Great plan until some Black Swan event comes along (like COVID, or the DotCom bubble or the 2008 crash or the next big one). You might even have only made your number because all your money was invested in booming stocks like Pets.com or
junk high yield bonds like unsafe toxic triple A MBS or in amazing companies like WeWork and your paper gains become paper pains! Poor performance in the early years of drawdown gives rise to the Sequence of Returns Risk (SORR).
Even in a well-diversified portfolio, there’s a risk you’ll be forced to sell in a bear/down market. Cashflow is king in early retirement as you can balance your future expenditure against future dividends (the yield shield) or plan periodic sells to top-up your bank account. Focusing too much in yield can lead you to making poor investment decisions (BTDT) – maximising income at the expense of growth. Studies have shown that avoiding wealth destruction in the first few years or drawing down is critical to avoid depleting your pot before you pop your clogs.
How VCTs can work for you
I’ve put together a few numbers here to show you what one strategy to use VCTs for Financial Independence. It’s quite straightforward and can be summarised as follows. Invest in VCTs, keep paying in until you retire, live off the sale of VCTs for 5 years and avoid SORR. But I’ll go into a bit more detail now.
Early Retirement Assumptions & Risks + VCT recap
For the purposes of this example, I’ll be drawing from my own experience and plans. It assumes that you have the free cash available to invest in VCTs after you’ve filled your ISAs, LISAs and SIPPS plus paid your mortgage, bills and credit card. I’m assuming that you’ve got a toleration of risk and a long game mindset for FIRE.
VCTs give you 30% tax relief on the money you pay in to them. Thy need to be held for 5 years before selling and they pay tax-free dividends in the meantime.
UK Tax Payer Income Tax Rates
Income tax is paid in the UK by everyone who earns money. You get a tax free allowance of £12,500 a year and above that basic rate tax at 20% is levied on salaries up to £50,000*. Above £50,000 tax is 40% and above £150,000 the rate is 45%. If you say earn £60,000 a year you would pay:
- Between £0 and £12,5000, 0% = £0
- Between £12,501 and £50,000, 20% = £7,500
- Between £50,001 and £60,000, 40% = £4,000
- Total Income Tax Bill = £11,500
For reasons I’ll cover below, you should probably put the £50-60k money into your SIPP to cut your tax bill and retain child benefit. Your salary/tax situation will look at bit like this from a very useful website called Listentotaxman.com.
After your SIPP/pension payments you are still paying about £7,500 tax. And this £7,500 basic rate tax can be offset by investing in VCTs.
- The tax relief of £7,500 requires £25,000 invested into VCTs (£25k x 30%).
- Your net wage, assuming £10k goes to the pension is £37,442 a year (tax plus NI are a stinger!) and from that amount you invest £25,000 in VCTs, getting £7,500 back from the tax man.
- You end up with almost £20,000 in cash from your salary, £25,000 in VCTs and £10,000 in your pension. Your tax bill is practically zero, and the money you’ve lost is about £5,000 in NI contributions.
The reduction in cash might makes things problematic. You may struggle filling your ISAs/LISAs or even paying your mortgage but it’s a pain that passes once your VCT dividends start flowing and you can start selling. It might be good practice to live like that too – get yourself used to being asset rich, cash poor!
VCT for Financial Independence: Lifecycle Cashflow
Assuming you invested £10,000 in year one to get a taste of things and £25,000 annually for a couple of years as you keep working away. You soon build up a nice portfolio of VCTs, tax relief is paid, dividends drip in and after 5 years you start selling. You decide that after 10 years, you want to pull the trigger and retire. From this point onwards you just sell the VCTs as their mature, still receiving some dividends and keep doing so until you have sold them all in year 15. In those 5 years, you’ve been able to extract over £25,000 a year – which should seem like loads compared to the £20,000 a year before. You’ve managed to sit out the sequence of returns risk an you should now be on an even keel to early retirement.
Worked example assumptions:
- 30% tax relief paid in same year
- 5% dividend yield paid annually on holding value
- 0% growth in value of VCTs
- VCTs sold after holding for 5 years
I’ve presented the table results in two graphs. The first graph shows a year by year picture of the annual cashflows. In this you can see that the grey line is money being pumped into VCTs less the tax relief and it rises to sit steady at £17,500 (£25k less 30%) until year 11 when it drops to £0. The dividends in orange rise and fall over the time period peaking at around £6,000 a year . The yellow line is for sales, which start 5 years after we start investing. Finally the blue line shows that the net cashflow for each year sits negative for the first 5 years as more money is invested than take out. Once the sales in year 6 start, the cash flow rises to £11,000 until year 11 when it rises to over £30,000 (dividends, sales less no new money going in).
The second graph shows your VCT holding and cumulative cashflow. Here you can see that your holding increases until year 6 when for every £25,000 you invest, you sell £25,000 meaning a stable £125,000 holding. From year 11 onwards, without new money coming in, the holding value drops to zero. From a cashflow point of view, the hard years are the early years. It takes a while for the dividends to start dripping in (and tax relief isn’t immediate). You keep pumping more and more money in and it’s only after 5 years that you hit the bottom, £63k in the hole). But from that point onwards, a combination of dividends (£6,250 a year on your £125,000) and a net gain from buying with tax relief and selling means that you hit break-even after 10 years. The final years sees annual cash-flow gains of £25,000+ year until you have nothing left.
Overall numbers show over the 15 year period, that you’d invest £235,000 into VCTs (of which £110,000 is recycled), the net cost is £164,500 (tax relief in initial investment). Over the time period, you’d receive dividends totalling £58,750 and your final cashflow position is plus £129,250 – as in you are left with an additional £130k from your 15 year adventure.
Pulling the trigger
If you decide that you want to pull the trigger and retire early. All you need to do is stop investing in VCTs and sell them as they hit their 5 year mark. This way you should be able to keep an income of £25,000 a year plus dividends for 5 years. Depending on your own circumstances, this money should be able to support some/all of your early retirement plans. Also, you might notice that £25,000 happens to be higher than the annual ISA allowance. If you step into part time work, selling off VCTs to fill your ISA might work out quite well – your day to day work can pay for day to day spending and you still get the ISA benefits.
VCTs compared to ISAs, Pensions/SIPPS
This section maybe deserves it’s own separate post but I’ve included it here below because the obvious question on VCTs is “should I bother?”
I’ve written about ISAs/LISA/SIPPs before. It’s a complicated picture and your own situation will vary depending on a range of personal and financial factors. For simplicity’s sake, I’m going to compare the return over 5 years of investing in a VCT vs. Cash ISA, GIA (general investment account), ISA, SIPP and Salary Sacrifice pension (for basic rate tax payer and higher rate tax payer). In this example £25,000 is invested each year (like in the example above) and the tax relief (if any calculated). VCTs are assumed to have Zero growth, Cash ISA 2% and everything else 7% growth. Pensions are taxed on the way our at 15% (20% less 25% tax-free lump sum) and the salary sacrifice saves on employees NI only. Percentage return is based on the final value vs. net cost.
The results show that salary sacrifice beats everything else hands down. That’s why I went mad for it back in the day. The SIPP for a 40% tax payer is pretty decent too – doubling your money. That’s the beauty of tax relief (or deferral) but you can’t touch that until you hit 58 – so what about our easier access options. Cash ISA is shit at 10% gained – but low risk. A GIA suffers from the tax but the ISA’s return is less than VCTs assuming 7%/0% growth. That might come as a surprise and if you pay around with the numbers you’ll find that even modest VCT growth trumps the ISA.
Past performance and growth rate estimates to Use?
I’ll cover this in part 4, showing my actual VCT performance vs. indices. But it’s safe to say that the benefit of the tax relief on VCTs means they do give ISAs a run for their money – and if your option is a GIA or VCT then VCTs are a contender. There’s another big surprise about VCTs that I’ll save until part 4.
Cashflow Positive Advantage
What I like about using VCTs as an early retirement bridge is that once you’ve been investing for a few years, they are cashflow positive – meaning that you get back more than they would cost to maintain at the same level. I’m seeing that now as some VCTs come up for maturity and the dividends keep dripping on. That positive cashflow coming in now is particularly useful when it came to supporting our family outgoings when our take home pay was less than our outgoings (combination of childcare, lifestyle and huge salary sacrifice).
So there you have it, a worked example of how you can use VCTs to glide into early retirement. It should be mentioned that the value of your VCTs may rise and fall and you may not be able to sell when you want for the price that you want. Any plan to use VCTs should include a back-up to prevent you from going broke. I’ve not mentioned the horrendous amount of fees you’d pay in this time or what else you could do with your money. Finally, in Part 4 I’ll share with you my experience of investing in VCTs – maybe you’ll learn from my mistakes!