Inheritance TaxJan 3 2019

Best options when investing for children and later generations

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Best options when investing for children and later generations

Two-thirds of inheritances of more than £1,000 received by 16 to 34-year-olds come from a grandparent or great-grandparent, according to the Office for National Statistics. 

These legacies might have more impact and be more tax-efficient if given earlier and in the donor’s lifetime, rather than on death.

Lifetime gifting

There are various tools available for effective inheritance tax planning, but one of the most effective is, simply put, time. Gifting earlier and more frequently can be effective for IHT planning and also help the recipient become used to managing money. 

Of course, the donor needs to ensure they are only giving away assets they do not require to maintain their own standard of living, and should keep back sufficient provisions to cover any potential future expenditure such as long-term care.

Gifting to a minor means the funds could be invested for a number of years, so taxation on the investments is an important consideration to maximise return. 

Parental settlement rule

Grandparents might often feel it’s simpler to give money directly to their own children and leave it to them to invest for the grandchildren. Care should be taken to ensure the parents aren’t seen as the donor of significant funds as this could trigger the parental settlement rule.

This rule apples where income received by a minor, unmarried child exceeds £100 per parent. If it does exceed £100, the full amount is taxed as the parent’s income rather than the child’s. This is generally less tax-efficient.

The parental settlement rule applies to income arising within a bare trust, bank account or Isa in the child’s name, as well as income paid to the child from a discretionary trust settled by the parent. 

However, it does not apply to income arising within a Junior Isa. So if a parent wants to irrevocably gift capital to their minor child, the Jisa can be the most tax-efficient method.

Junior Isa

Jisas benefit from the same tax advantages as regular Isas, but cannot be accessed before age 18 unless the child is terminally ill. The Jisa allowance for 2018-19 is £4,260, with the recent Budget announcing an increase to £4,368 for the 2019-20 tax year.

With modest tax-free growth and inflation-linked increases in the allowance, a Jisa opened for a newborn child could be worth a six-figure sum by age 18. It can then roll into a regular Isa to retain the tax-efficient wrapper. A lump sum can be withdrawn – for example, to fund a house deposit – with no need to worry about crystallising gains over the capital gains tax annual exempt amount.

From age 16 an individual has a full adult Isa allowance of £20,000, which is independent of the Jisa allowance. This means that across three tax years a child can make use of both a Jisa and regular Isa allowance. An example is given in Box 1

A lifetime gift to a Jisa or Isa from a third party is a potentially exempt transfer, so aside from the seven-year window there are no ongoing IHT implications for the donor.

Bare trust

A bare trust can be the simplest way to pass wealth to a minor. Any gains and income within the trust are taxed on the underlying beneficiary. 

A minor has a personal allowance, savings rate band, personal savings allowance and dividend allowance for income and an annual exempt amount for CGT purposes – so there could be minimal, if any, ongoing income tax liability. Again, any gift made by a third party to a bare trust is a PET.

The advantage of a bare trust over a Jisa is that both capital and income can be accessed before age 18 if it is used for the child’s maintenance, education or benefit. This could be useful, for example, to help towards driving lessons or educational trips.

Note that for trusts coming into force before October 1 2014, payments of capital before age 18 may be restricted by statutory provisions in the Trustee Act 1925 to one-half of the beneficiary’s share. The Inheritance and Trustees Powers Act 2014 amended this to allow the whole amount to be paid out. 

In all cases, an express clause in the trust deed may override the statutory provisions regarding paying out income and capital.

Pensions

Those concerned about a child being able to access potentially significant amounts at age 18 can go to the other extreme and make contributions to a pension, where the funds will ordinarily be inaccessible for decades.

Non-earners, including minors, can receive basic rate income tax relief on contributions up to £3,600 gross, provided those contributions are made to a pension scheme operating relief at source. 

A grandparent could make a contribution of £2,880 on a child’s behalf every tax year. This would be a gift for IHT purposes, but could fall neatly within the grandparent’s annual £3,000 gifting exemption, or qualify as normal expenditure out of income. That makes it a very tax-efficient, albeit long-term, means of gifting. 

Discretionary trust

A middle ground in terms of accessibility might be a discretionary trust, where no individual has an absolute entitlement to either capital or income from the trust. This can be particularly useful if there is the possibility of more (great-) grandchildren. 

Trustees have discretion over who benefits, when they do so, and by how much, so it removes the potential for an 18-year-old receiving a large lump sum at a time they may not have sufficient financial awareness to cope with such a windfall.

In return for this flexibility, the tax burden can be significantly higher than a bare trust. A gift into a discretionary trust is a chargeable lifetime transfer for IHT purposes, so the trust is potentially subject to entry charges, periodic charges at up to 6 per cent every 10 years, and exit charges. 

Income retained within the trust is taxed at trustee rates of 45 per cent for both dividends and fixed interest, and gains at 20 per cent (28 per cent for residential property). In addition, the administrative burden on the trustees is higher.

Family members can be keen to start saving and investing for the younger generations. The timescales involved mean that growth and income can quickly add up. If both the parents and grandparents want to contribute they should work together to optimise the tax position and maximise use of the child’s tax allowances.

Victoria Harman is senior technical expert at Hargreaves Lansdown