My wife has a big — but welcome — problem with her pension. Her £1m pension pot is so large that it might trigger hefty tax bills. I know, rich people’s problems, urgh. However, this fund was the fruit of over 30 years of hard work and long-term investing.
A £1m pension fund can attract tax
By working hard and investing harder, my wife has greatly boosted her retirement income. However, the taxman’s Lifetime Allowance limits how big pension pots can grow.
In 2011-12, this stood at £1.8m, but fell to £1m by 2017-18. It was then raised over time, reaching £1,073,100 in 2022-23. My wife’s pension is valued at this limit. Any excess above this threshold will be taxed at 55% if taken as a lump sum, or 25% if taken as income or drawdown. Yikes.
Building a fat fund
My wife’s pension has two parts. The taxman values her final-salary pension at £440,000. The remainder is an investment fund worth over £600k, funded mostly by paying in extra contributions over decades.
What’s remarkable is that two-thirds of her pot (£400k) came from long-term investment returns. This shows the incredible power of compound interest, rolling up returns from shares over decades.
Compound interest is a wonderful tool
Even today, I could still build a £1m pension pot without generous employer support. If I invest £300 a month for 40 years, my total contributions would be £144,000. But if this pot grows at 8.5% a year compounded, my total investment gains would be £968,856. And my total fund would be worth £1,112,856
In short, with dedicated long-term investing, building a £1m pension pot can be done. But how would I do it, starting out today?
I’d own 20+ dividend shares
My wife partly built her investment pot by investing in various low-cost, index-tracking funds. But as a veteran value investor, I’d aim to replicate (or beat) her returns by buying London-listed dividend shares.
I’ll set my goal as the 8.5% yearly return I used in my above calculations. I’d aim to earn at least half of this (4.25% a year) from cash dividends and the other half from capital gains made by selling shares at a profit.
The good news for me is that the UK’s blue-chip FTSE 100 index is packed with shares offering market-beating dividend yields to long-term investors like me. Right now, the Footsie itself pays a cash yield of around 3.7% a year.
However, I count at least a dozen big companies paying dividend yields above my benchmark 4.25% a year. These dividend dynamos include major banks (such as Barclays and Lloyds Banking Group), giant mining companies (Rio Tinto), asset managers (Legal & General Group) and telecoms firms (Vodafone Group).
Finally, my wife and I already own all five of these dividend stocks in our family portfolio. And we aim to make even more from these and our other cheap UK shares in future!
The post How to target a £1m pension pot to retire early appeared first on The Motley Fool UK.
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Cliff D’Arcy has an economic interest in Barclays, Legal & General Group, Lloyds Banking Group, Rio Tinto, and Vodafone Group shares. The Motley Fool UK has recommended Barclays Plc, Lloyds Banking Group Plc, and Vodafone Group Public. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services, such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool, we believe that considering a diverse range of insights makes us better investors.