Investing for Children
Tony Wickenden, Managing Director at Technical Connection, explains how to invest for children.
Ask anyone who’s a parent or grandparent to name what’s most important in their lives and its odds-on that their children or grandchildren will be way up there - most likely top of the list.
And, when you ask about their concerns and anxieties connected with their children or grandchildren, you will often discover that education, career and getting onto the property ladder, along with being “looked after” should you not be around to do so will figure strongly. For those parents and grandparents who are a little older the challenge of inheritance tax and its potentially negative impact on intergenerational transfer is also likely to be relevant.
When it comes to addressing those financial concerns, the earlier you start and the more tax efficient you can be, the better.
In practice, savings and investment for children is almost certainly going to be founded on contractual arrangements made with the parents and/or grandparents. While, in theory, a minor may own all types of personal and moveable property other than land, in reality this will not usually be viable due to the fact that children do not have the contractual capacity to be able to purchase or otherwise deal with investments.
Investing in the name of the child – JISAs, pensions and deposit accounts
A minor’s capacity to make a valid contract is limited to contracts for necessaries and contracts made for the minor's benefit (such as contracts of apprenticeship, employment, training or education). In other cases, contracts made for minors will be altogether void or voidable by the minor before or within a reasonable time of him reaching majority.
Consequently, where there is a desire to make an investment in the name of a minor, choice will usually be restricted to Junior ISAs (JISAs), third party pension contributions and/or bank or building society accounts. Some of these can be opened in the name of a child as young as seven.
JISAs certainly have their place, particularly in cases where the funds are derived from the child’s parent(s). They provide a unique opportunity for the generation of income and capital gains that are not taxable on the potentially higher-rate taxpaying parent or other donor. The amount that can be subscribed annually is limited to £9,000 per annum (2021/22) and there is no scope for access to the invested funds until the child takes control of the JISA at age 18. But then again, the child will become entitled to the JISA at age 18, regardless of the circumstances or the parent’s preference for continued control.
Looking at tax efficient investment for the even longer term, pension funds have to be considered. Once again, there is a contribution limit. The gross annual contribution will be limited to £3,600, meaning an annual net contribution by the parent of £2,880 with the rest made up by tax relief - not a bad start to your tax efficient savings journey! All of the income and capital gains generated by the invested funds will then be tax free. The power of long-term tax free compounded growth really can’t be underestimated. The accumulated fund will not be accessible until the child’s 57th birthday at the earliest but many parents and grandparents will see this as an advantage. The amount that can be deposited in bank and building society accounts is, of course, unrestricted – and the deposits can be accessed for the benefit of the child during the child’s minority – but such vehicles, as well as offering very little in the way of yearly interest currently also offer little opportunity for real growth. If the funds are deposited by the parent of a minor child beneficiary, the income produced will be assessed on that parent if it exceeds £100 per annum.
Bare trusts and using the minor’s tax allowances
Where the funds to be invested for a minor unmarried child have originated from someone other than a living parent, a bare trust can provide opportunities to generate tax-free returns by using the child’s personal income tax allowances. Using a bare trust means that there is a gift to the child at the time the investment is made. This will usually be a potentially exempt transfer (PET) if a lump sum is invested, although regular contributions may be exempt gifts for IHT purposes if made from surplus income. As there is no scope to change the beneficiary, income will usually be assessed as the child’s, who is likely during their minority to have a full personal income tax allowance and dividend allowance available to them. Dividend income in excess of these allowances is likely to be taxed at just 7.5%.
The only exception to this rule is where the funds are derived from a living parent. Here the parental settlement rule will apply, which means that if the income generated by the investment exceeds £100 p.a. it will be taxed on the donor parent.
That said, capital gains will be taxed on the child regardless of where the funds have originated from. This means that there is scope for tax-efficient capital growth though smart use of the child’s annual CGT exemption.
In addition, if access to the investment funds are required for the child during their minority this will also be possible. The investment can be transferred into the control of the child at 18 with no further CGT or IHT consequences, or it could continue to be held in trust though the child could demand payment if they wished.
Using discretionary trusts with collective investments for added flexibility and control
Using discretionary trusts to hold investments earmarked for children provides the donor, who will usually be one of the trustees, with added control. This may be seen as an important feature, especially by those a little concerned about the automatic vesting of a JISA at age 18 or access at age 18 with a bare trust. Discretionary trusts can provide the potential for flexibility – with the settlor or trustees being able to decide which of a range of possible beneficiaries will benefit and when. And, of course, the trustees can access the funds for the benefit of the beneficiary at any time (subject to the terms of the trust) or change the investments as required without impacting on any IHT planning which may have been a motivation for creating the trust.
Using trusts with income-producing/chargeable assets, such as collective investments will, however, have tax implications and these differ depending on the type of trust that is used.
Tax implications of using trusts
Bare or absolute trusts
A bare or absolute trust is transparent for tax purposes, with income and gains taxed with reference to the minor beneficiary’s tax position. If the parental settlement rule applies, income – but not gains – will be taxed as that of the parent to the extent that the £100 annual threshold is exceeded. Where the gift is being made by the beneficiary’s parent, an investment in low-yielding collectives may therefore be appropriate - at least from a tax standpoint.
Regardless of who is the settlor, with a bare trust the beneficiary will have the right to call for distribution of the trust funds at 18 without any further tax consequences at that time.
Discretionary trusts are a popular choice when investing funds for the ultimate benefit of children who are minors at the time the gift is made, due to the fact that no beneficiary is entitled to capital or income. This means that the trustees can decide when and to what extent to benefit individual beneficiaries according to circumstances and objectives – withholding funds to beyond 18 if desired.
Because a gift to a discretionary trust is a chargeable lifetime transfer (and the trust itself is subject to the relevant property regime of IHT ten-yearly ‘periodic’ charges and interim exit charges), caution needs to be exercised if the amount(s) gifted are close to or above the nil rate band(s) available to the settlor(s), to prevent a lifetime charge to IHT. This would be at 20% of the balance over the settlor’s available nil rate band.
If discretionary trusts are used to hold collective investments for the benefit of minor children, consideration will also need to be given to the income tax position. This is because income will only be assessed on the minor beneficiary if income is actually distributed to them. If income is accumulated within the trust, it will be taxed at the trust rates - of 38.1% in the case of dividend income, and 45% in other cases - to the extent it exceeds the trust’s standard rate band. Income falling within the trust’s standard rate band – which is £1,000 in most cases – is taxable in the hands of the trustees at the relevant basic rate.
Where income is distributed, the beneficiary will often be able to reclaim some or all of the tax paid by the trustees; however, it is important to remember that if the income is distributed to a minor child of the settlor, the amount of tax (if any) that can be reclaimed will depend on the tax status of the parent settlor. Note too that income distributions received by a beneficiary from a discretionary trust are taxed as non-savings income in the hands of the beneficiary, which means there is no scope for the beneficiary to offset his or her dividend allowance, starting rate band for savings or personal savings allowance against the income receipt.
Gains made by the trustees on the disposal of collectives will be assessed on the trustees at the trust rate of 20%. An in specie distribution (i.e. transfer of the unit trust or other collective) to the beneficiary will also be a disposal. However, in this case it should be possible for the trustees and beneficiary (if by then an adult) to claim gift hold relief. This provides an opportunity to make significant tax savings if there are multiple beneficiaries, each with full CGT annual exemptions and who pay CGT on gains above their annual exempt amounts at basic rate.
A capital distribution to a beneficiary – whether of cash or otherwise – could also give rise to an IHT exit charge if the trust fund has by then grown to be worth more than the nil rate band available to the trust.
Investment bonds for minor beneficiaries
Investment bonds are subject to their own taxation regime, known as the chargeable event regime. The unique features of this regime can make bonds particularly attractive as trust investments for those with capital to invest – especially where the beneficiaries are minors. For example, if the trust is a discretionary trust, and the trustees do not intend to make regular distributions during the beneficiary’s minority, the non-income producing nature of the bond means that there is no ongoing liability to tax at the high trust rates and no need to complete tax returns…tax efficiency and administrative simplicity. A pretty good combination!
Tax liabilities will, of course, occur when chargeable gains are realised. If these are made by trustees of a trust other than an absolute trust, they will be assessed to tax on the settlor if living and UK resident or otherwise the trustees if UK resident.
While it is possible to assign cluster policies to beneficiaries (and the assignment will not count as a chargeable event) to allow the beneficiary to encash with reference to their own tax position, a minor beneficiary doesn’t have the capacity to give a valid receipt for the proceeds to the life company. In this situation, the trustees could therefore consider irrevocably appointing the number of cluster policies that they wish to encash to the beneficiary before making the encashment. As only the beneficial ownership has been changed, the trustees remain the legal owners of the policies and can therefore still surrender them themselves. However, the irrevocable appointment has effectively turned the trust into an absolute trust as far as the appointed policies are concerned, which means that the gain will be assessed on the beneficiary.
Another way of realising funds tax efficiently is to make distributions for the benefit of the beneficiaries (eg to meet the costs of education) – particularly while the children are under 18 - is for the trustees to access the 5% tax-deferred allowance. This could provide trustees with the means to access capital to advance without creating an income tax charge for the parent settlors.
As a general rule of thumb, then, bonds tend to work well with discretionary trusts as there is:
· No ongoing income tax liability for trustees/settlor
· The trust administration and reporting is simplified
· The bond provides tax-efficient distribution options.
BUT the potential income tax savings need to be balanced against the possibility of IHT exit charges on high value trust funds – especially if regular distributions are likely. Expert advice is essential.
So, in summary, where clients want to help children progress through the financial landscape, there are plenty of options to consider. However, there are equally plenty of tax traps to be wary of, particularly if the client is looking to make tax-efficient provision for their own child.
And remember that as well as investing for children, there’s also “providing for them” and this brings in the all-important skillset of inheritance and intergenerational tax planning using appropriate product and trust combinations. In this it’s essential, given that the limelight is understandably given to bond/trust solutions like loan trusts and discounted gift trusts, not to ignore the power and importance of ordinary protection-based life insurance held in trust to provide money, tax efficiently, in the right hands at the right time.