As the boss of RBS turns down a huge bonus, how would you handle such a sizeable sum?
The past week has not been a pleasant one for Britain's so-called 'fat cats'.
First, the remuneration committee of Royal Bank of Scotland (LSE: RBS) voted to cut this year's share reward for chief executive Stephen Hester by two-fifths. Thus, instead of receiving six million shares, Hester got only 3.6 million, vesting over the next three years.
However, under tremendous pressure from politicians and the media, Hester agreed to waive his entitlement to a bonus. As a result, he has turned down a sum worth just over £1 million at the current share price.
On Tuesday, the ex-CEO of RBS, Sir Fred Goodwin -- who presided over the bank's near-collapse and £45 billion bailout by taxpayers in 2008/09 -- was publicly humiliated. On the advice of civil servants sitting on the Honours Forfeiture Committee, Her Majesty the Queen annulled Sir Fred's knighthood, previously awarded in 2004 for services to banking.
Thus, in a peculiarly British outcome, we have punished both the destroyer of RBS and its rescuer!
A whopping windfall
Of course, what starts out as a cool million ends up as considerably less, thanks to income tax and National Insurance contributions. On earned income above £150,000, the combined tax rate for income tax and NICs is 52%. Thus, without careful tax planning, close to half of this windfall would end up in HM Treasury's coffers.
Even so, what would you do if you found yourself a million pounds richer? Would you buy a dream home? Would you opt for a performance sports car? Would yours become a life of luxury foreign holidays, or would you donate large sums to charity?
Fool regulars will easily guess what I would do. Of course, I would use it to boost my future financial security by investing the lot. What's more, I wouldn't be the only Brit to do so. A survey in July 2011 found that a quarter (25%) of people hoping to win a lottery jackpot would save their entire windfall.
Investing my million
I wouldn't use this windfall to buy a family home. In my view, despite a dip in property prices since they peaked in mid-2007, UK homes are still unrealistically over-priced.
Then again, simply saving this sum in cash would not generate that great an income. In a savings account paying 3% a year before tax, £1 million would produce a before-tax income of a mere £30,000 a year. After tax, this could amount to less than £2,000 a month.
Thus, I would abandon the safety and security of savings, in favour of taking more risk with my capital to chase a considerably higher income. Through careful 'asset allocation' (spreading my money across different 'asset baskets'), I would aim to generate a growing income.
Here are four asset classes I would gradually move my million into:
1. Property
As I've said, I'm not a fan of domestic property, but yearly incomes of 6% or more are on offer from property funds or Real Estate Investment Trusts (REITs). REITs spread their risk across UK commercial and foreign property, making them less volatile than investing directly in bricks and mortar. In addition, REITs pay out the majority of their profits as dividends to shareholders.
2. Bonds
Bonds are IOUs issued by governments and companies. These debt investments pay a fixed income -- known as the coupon -- throughout their life, before returning your investment on maturity. I am keen on corporate bonds, as coupons of 6% or more can be had by buying the debt of some of the UK's strongest companies.
However, I wouldn't touch most government debt with the proverbial barge pole. For instance, 10-year Gilts (UK government debt) pay a pathetic 2% a year. What's more, I am firmly of the view that government bonds are enormously over-priced. Bondholders could get their fingers badly burnt if interest rates start to rise in the years ahead.
3. Cash
Thanks to the Bank of England's base rate being stuck at 0.5%, British savers have suffered the lowest interest rates in modern history. Even so, when times are hard, cash is king. Hence, I would keep, say, £100,000 to £200,000 on deposit in a high-interest savings account to cover emergencies and to buy cheap assets during market downturns.
4. Shares
I've saved the best for last. Of these four asset classes, my biggest exposure would be to shares.
Alas, the blue-chip FTSE 100 index is at the same level as it was in February 1998, so it has gone nowhere for 14 years. However, dividends (the yearly cash payouts to shareholders) rose steeply in 2011. Right now, 15 Footsie firms have dividend yields of 5% or more, making them very attractive to income-seekers.
Top tax shelters
Now for a word about tax planning. With my hypothetical windfall generating an income of £50,000 to £60,000 a year, I would take serious steps to minimise my tax bill.
Obviously, I would begin with ISAs (Individual Savings Accounts), which are the UK's most popular tax shelter, as used by nearly 20 million savers and investors. Alas, only £10,680 can be sheltered inside a stocks and shares ISA this tax year. Thus, my wife and I would need 94 separate ISAs to shelter £1 million from tax!
Therefore, I would also grab the tax relief on offer from investing in pensions, into which I could put up to 100% of my earned income each tax year. In addition, I would look into more obscure tax havens such as Venture Capital Trusts (VCTs) and Enterprise Investment Schemes (EISs).
Finally, I would never allow 'the tax tail to wag the investment dog'. In other words, I wouldn't buy any asset purely for its tax breaks. Instead, my wealth-building would be driven first by income and then by risk and volatility. In short, any tax breaks would be only the icing on my investment cake.
What would you do with a million? Please tell us in the comments box below…
