Tax efficient saving for your children’s future
With the costs of attending university or funding a first property deposit at all-time highs, many parents and grandparents are keen to look at the most efficient ways of long term saving or investing for children.
Children face a financially challenging future on two fronts; firstly, university costs have increased dramatically over the past few years, with tuition fees and livings costs for a three year course easily exceeding £40,000, and second, rapidly rising property prices has made that first step on the housing ladder ever harder to achieve.
Additionally, changes to mortgage rules in 2014 mean lenders assessing mortgage applications now need to look not only at the level of deposit and income, but at fixed outgoings, which in many cases will include student debt repayments.
For the average graduate starting work on a salary of £25,000 having accrued £40,000 of student debt, their total repayments will be in the region of £56,000 once interest is added and the loan won’t have been repaid until around the age of 45. Time out of the workplace, for example for career breaks or child care duties, will see total payments increase through the addition of further interest and their ultimate repayment age increase, with any remaining debt written off after 30 years.
Given these combined challenges then, it is understandable that parents and grandparents are looking for the best way to secure the financial future of children or grandchildren.
The starting point
Before deciding on the home for any savings for your children, there are some questions which will ultimately guide this decision:
- Are investments being made by parents or grandparents (or others)? Depending on the product used, income of over £100 on money gifted from parents will be taxed on that parent. These rules do not apply to grandparents or others.
- Will savings be made regularly or by way of a lump sum? With other financial priorities, parents are often not able to gift or save large lump sums, but save regularly out of income, whereas for grandparents, lump sum investment might be an option.
- Is the investor willing to give up future access to the investment? Or would they prefer to retain access and control over when and how much the child benefits from the investment by adopting more of a ‘wait and see’ approach?
The options available
Here, we will look at the main options available for saving for children, considering tax efficiency as well as the level of access and control that will be retained over the investments.
A Junior ISA (JISA) is now available for any child under the age of 18. Although it is not possible to have both a JISA and a Child Trust Fund (CTF), from April 2015 it has been possible to transfer a CTF into a JISA, opening up a wider number of providers and investment options.
A parent needs to set up the JISA, after which anyone can pay into it up to a maximum permitted investment of £4,080 per year (at 2015/16 rates). JISAs can be invested in cash or stocks and shares, the latter frequently being preferred for long term investment where growth is key, before moving to less potentially volatile investments as the child approaches age 18 when they may need access to the money to fund university costs.
In the same way as regular ISAs, no tax is payable on income or capital gains made within the JISA. In addition, JISAs are not caught by the £100 income tax-avoidance rule mentioned above on contributions from parents, so they are ideal for parents wanting to regularly save for their children.
Assuming no increase in annual ISA allowances, a net investment return of 5% and the maximum £340 being saved each month from birth up to 18, the child will have access to over £118,000 at age 18. Even saving from age 10 would result in a sum of £40,000 being available, which at current rates should be sufficient to cover the costs of a three year university degree.
Although not accessible by the child until age 18, at that age a JISA becomes a regular ISA, and the child will automatically have access to the money within it and could use it for university costs, as a deposit on a house, or for any other reason. Of course they could leave it invested, and continue to contribute to it if the money was not immediately required.
Cash ISAs for 16 and 17 year olds
At 16 and 17 years old, children can save more than their parents into ISAs.
Not only can £4,080 be saved into their JISA, but they can also have a cash ISA and contribute up to the full ISA allowance of £15,240 (15/16) as well. Once the child reaches 18, they will no longer be able to contribute to the JISA, but could continue to save £15,240 into either a cash or a stocks and shares ISA, or a combination of the two. However, any money gifted from a parent to a child’s cash ISA at age 16 or 17 would be caught by the £100 income tax avoidance rule, meaning any income over £100 would be taxed on the parent, although note that the limit is per parent, so an equal gift from two parents could see £200 income before this would occur.
ISAs in parents’ names
Parents who are concerned about their children having access to a significant sum of money at age 18 could decide to save in their own name through regular ISAs, into which a couple could save £30,480 in each tax year. The money would accrue virtually free from tax, and at age 18, when the plans of the child are known, they could begin to encash investments to pay for university costs.
Parents in the position of being able to afford to maximise ISA contributions each year for 10 years would build up £394,000 assuming a 5% net investment return, a sum that could easily see children through university and help with a house deposit, while possibly leaving a significant sum to help with their own financial future.
Other investments in parents’ names
ISAs should always be a starting point for tax paying individuals thinking about making regular savings, given their almost complete freedom from income and capital gains tax. Once ISAs have been considered, however, what other investments can parents make in their own name but for the benefit of their children?
Aiming for investments to be as tax efficient as possible, and given the relatively low rates of tax on capital gains compared to income, they could, for example, regularly invest in collective investments aiming for capital growth. When investing over the long term, encashing investments gradually (for example every university year), and taking into account the annual capital gains tax (CGT) allowance of £11,100 on encashment, the investor could take a stream of payments from the investment in the most tax efficient way possible.
Lump sum investing
Along with the obvious of ensuring lump sums are invested appropriately, taking account of the aims of the investment, timescales and ability to take investment risk, the main aim should be to achieve maximum tax efficiency with any lump sum investment. Various approaches are possible depending on whether the person making the investment wishes to keep or give up access.
For those who want to make lump sum investments for children but keep access and control, perhaps waiting until the university plans of the child is known, they could consider investing in an offshore bond, or in growth-focussed collective investments. The person making the investment could retain complete access, control and ownership of the investments.
Growth-focussed collective investments could be encashed when needed, and the investor could take advantage of their annual CGT allowance of £11,100 to manage any tax liability.
Although charges can be slightly higher when investing in an offshore bond, the main advantage of this approach is the virtually tax free roll up on the underlying investments. When the plans of the child are known, and access to the funds required, all, or part, of the bond could be assigned to the child for them to encash.
Assignment by way of a gift is not a chargeable event for tax purposes, which means tax would only become payable on the holder of the bond at encashment, in this case the child. Given that children have their own income tax allowance, it could be arranged so on encashment of the bond, or segments of the bond, any gain is within their personal allowance and therefore tax free.
In addition, as gains on offshore bonds are treated as savings income, assuming the child had no other income within that year they could take advantage of the 0% tax rate on savings of up to £5,000, meaning they could in theory see a gain of £15,600 (in 2015/16) with no tax charge.
Of course, keeping access and control over the investment means it is within the estate of the investor for inheritance tax purposes until it is assigned to the child, at which point it becomes a Potentially Exempt Transfer, falling out of the estate after seven years (see here for more information about inheritance tax).
Giving up access
If the investor is willing to give up personal access to the investment, then a trust arrangement could be considered. The type of trust used will depend on the view of the person making the investment.
1) Bare trust
For example, if they are confident the child will be able to be trusted to use the investment wisely, they could invest in a collective investment or a bond through a ‘bare trust’, which has a defined beneficiary or beneficiaries which cannot be altered by the trustees. The trustees effectively have no discretion over who benefits from the trust, although they still need to ensure it is invested appropriately. Normally, on reaching age 18, the beneficiaries will be able to access their share of the trust, whether or not the person making the original investment or the trustees want them to.
Advantages of a bare trust are mainly in relation to its tax treatment – any income and gains will be taxed on the beneficiary of the trust, and any investment into the trust is a Potentially Exempt Transfer for IHT purposes as soon as the transfer is made, meaning if the investor lives at least seven years after investment, it falls out of their estate for the purposes of Inheritance Tax.
2) Discretionary trust
Unlike a bare trust, the discretionary trust gives control to the trustees over the eventual beneficiaries. The person establishing the trust can provide a letter of wishes setting out their preference, and can provide a list of potential beneficiaries, but the trustees retain ultimate control over who benefits, how and when.
The downside of the discretionary trust is that any income is taxed on the trustees as if they are additional rate taxpayers, meaning 37.5% tax is paid on dividend income and 45% tax on all other income. It could, however, be arranged for an investment to be made into either growth producing assets (taking advantage of the trustees’ annual CGT exemption which is usually £5,550) or in non-income producing assets, such as investment in an offshore bond. The trust can then apportion part of the capital to the beneficiary when needed.
The treatment of discretionary trusts for Inheritance Tax is relatively complex, with a potential immediate liability to inheritance tax at outset as well as periodic charges and exit charges, and so it is vital that professional advice is sought before creating a discretionary trust.
Early financial planning by parents, grandparents and others can help children fund university costs, their first property purchase or simply provide a lump sum to ensure they have the best possible financial start to their adult life. Ensuring the right financial products are used can help maximise tax efficiency, while providing the right level of access and control for the person making the investments, taking into account their own circumstances and wishes for the investment.