Planning your financial future can be a daunting task at the best of times. It can require a degree of introspection around the ‘big’ life moments e.g. when can I afford to retire, which can appear intimidating. For this reason, the use of cashflow modelling can offer a sense of reassurance and is a useful tool to implement a holistic approach to an individual’s finances.
What is cashflow modelling and how can it help me?
Cashflow modelling is a comprehensive overview of an individual’s assets, liabilities, income and expenditure projected over time to evaluate the suitability and ability to cover future financial needs and objectives. Based on a series of assumptions from macro aspects of inflation and growth to future income and tax considerations, It can help you to plan your financial future by providing a tool to think through a variety of questions including:
- How do I achieve my financial goals? Whether that may be buying a second home, paying off debt or gifting money to relatives.
- When can I retire with my desired lifestyle?
- How does my investment strategy handle incidents of significant loss?
- Where should I choose to take income from?
Your financial advisor can then combine the cashflow modelling with your investment objectives and create your investment strategy. As with all models extending into the future, these assumptions must be continually adapted to ensure they are still reflective of real life. However they allow families to garner an understanding of how their wealth will develop over time and the options this may or may not provide for them.
Common Issues
Unfortunately, the vast majority of cashflow modelling tools are aimed at those in the early stages of their wealth generation and typically focus on one jurisdiction. Whilst this can be hugely valuable for these families, this often renders them only party beneficial for families who have built up wealth over time in different countries and are looking to now live and give with that money.
On top of this, the various rules that apply to accounts in different jurisdictions mean that often cash flow modelling can be more complex than when dealing with a single jurisdiction, where the usual income generation, inflation and home country tax factors apply.
Four things to keep in mind
Below, we highlight some of the most common complicating factors which need to remain paramount when cashflow modelling with an American connected family who has assets both in the US and also offshore.
01 Multiple Tax Jurisdictions
The USA is one of the few nations to tax citizens on their worldwide income, regardless of their residency. In short, this means international Americans often contend with the task of complying with multiple tax jurisdictions when residing outside the US.Through precise implementation it is possible to build a model which can incorporate the differing tax rates. The Internal Revenue Service (IRS) (currently, and who knows for how long?!) taxes ordinary income at rates up to 37%, whereas HMRC charges up to 45%, compound this over 5 years and the difference can be over 50%.
The overall effect of not accounting for the tax accurately could significantly affect your long-term financial plan.
02 Foreign Exchange (FX)
All too frequently we see American families being required to exchange all their holdings to a common currency to benefit from a cashflow exercise. As an example, an American living in the UK would convert all account values held outside of the UK to Sterling to satisfy the single currency conundrum.This conversion can cause inaccuracies when forecasting over lengthier periods of time. We can mitigate the imprecisions of FX’ing pots where it is not necessary, by keeping the accounts in their respective base currencies.
Whilst this issue cannot be resolved entirely, due to volatility of foreign exchange markets and external macro-economic factors. Regular reviews of the model with your advisor can allow for the assumptions to be updated, and financial objectives be assessed.
The assets should not be manipulated to fit the model, instead the model should be reflective of what you actually have.
03 US accounts
Another hurdle to overcome when building a cashflow model for Americans is account or product types that differ from those traditionally seen by UK managers. To the uninitiated, an Individual Retirement Account (IRA) may appear to be like the UK equivalent Self Invested Pension Scheme (SIPP).
On the face of it both are investments used for pension purposes funded gross, withdrawn net and grow tax free inside the wrapper. However, Uncle Sam and the IRS have other ideas. The IRS enforce Required Minimum Distributions (RMDs) as annual mandatory distributions upon all IRAs when the holder surpasses the age of 72. The withdrawal is at a factor rate based on the account holder’s age, and if not taken a potential tax penalty of 50% of the missed distribution. This is significantly different from the SIPP, which has no distribution requirements and is excluded from your estate on death.
Ensuring that the RMDs’ effect on your tax rate and reduction of your tax-free growth pot has been taken into account when evaluating your income requirements in retirement, is key.
04 Gifting
A consideration for most in the latter stages of life is gifting in the most tax-efficient manner. The discussion may be to make use of the historically high lifetime allowance for US citizens ($12.06m in 2022); or creating a plan to utilise the UK’s Potentially Exempt Transfer (PETs) rules and evaluate the suitability.
An effective cashflow can merge your investment and financial plan into a simple model, built to factor in multiple objectives or ‘what-if’ scenarios. When constructed to accurately reflect the families requirements or circumstances, it is an invaluable tool for the donor to understand the implications on their own finances for giving away their wealth.
This is by no means an exhaustive list, but instead it raises some of the most common shortfalls of what is otherwise an extremely useful exercise for all families regardless of wealth. Done properly across your entire wealth and with an understanding of all the facets that effect it, this can provide real comfort and understanding to what otherwise can result in unnecessary cost and stress.
