Independent education fees are not cheap. According to the Independent Schools Council Annual Census in 2015, the average annual fees are £11,970 for Junior School, £16,704 for Senior School and £20,838 for Sixth form. Meanwhile university tuition fees in England and Wales can now be as high as £9,000 per year, with living costs on top. This causes a headache for most fee paying parents.
With education fees on the rise and a strong desire to help our children and grandchildren through these years, I’ve put together a guide on how the tax system can help manage these costs. My fictional Grandad scenario may sound similar to your current situation, and hopefully will be helpful in the options on offer.
Say Grandad wants a tax-efficient investment to fund school fees for his two grandchildren, Lily aged four and Oliver aged one. He has a lump sum of £250,000 which he is prepared to use for this purpose. The fees will be required from age seven (Prep School) through to age 18 (Sixth Form). Grandad has discussed this with Lily and Oliver’s parents and they are delighted that he can cover the school fees, as this will give them time to save for future university costs.
In this instance an international investment bond is an ideal way to invest for school fees because
(a) the investment benefits from gross roll-up, which will boost the fund over time,
(b) the bond can be split into smaller policies or segments allowing for greater flexibility when the school fees are required, and
(c) no tax is deducted within the fund (except perhaps any foreign withholding tax deducted in the country of origin which is non-reclaimable) which allows non-taxpayers to offset their personal allowance (£11,000 2016/17) before any tax is due. In addition, there is a starting rate band of £5,000 for investment income, taxed at 0% and the new personal savings allowance of £1,000, also taxed at 0%.
Who holds the bond?
If Grandad holds the bond in his name, then on encashment of segments to meet the school fees, any tax liability will be based on Grandad’s marginal rate – and he is currently a higher rate taxpayer. One way to avoid or reduce this tax would be to place the bond under a bare trust.
Trustees will hold the bond. A bare or absolute trust is for a named beneficiary or beneficiaries and it states at outset the share of the assets for each beneficiary. This share cannot be altered in the future. A discretionary trust could be used where all beneficiaries are merely ‘potential’ beneficiaries and the trustees decide who gets what and when. However, under a discretionary trust, the tax treatment of any gains on the bond would fall on Grandad at his marginal rate while he was alive and then at the rate applicable to trusts (currently 45% after the £1,000 standard rate band has been utilised) from the tax year after Grandad died.
Grandad decides to set up two bare trusts for £125,000 each, one for Lily and one for Oliver. The downside to bare trusts is that the child could demand the whole of their share when they reach age 18 – but in this example, it is likely that the school fees will have used up virtually the entire trust fund by the time Lily and Oliver reach age 18, so Grandad is not worried about this aspect.
Based on the current average fees, and assuming a modest 5% per annum increase, with fees to start in three years for Lily and six years for Oliver, would require a total of £197,110 for Lily and £228,181 for Oliver. If we assume the international investment bonds of £125,000 each grow by 5.8% after charges they will produce sufficient growth to meet the full costs for both – with a surplus for Lily of £5,347 and Oliver of £13,126.
There are two different ways of extracting cash when the fees are due.
The trustees can take a partial withdrawal across all segments. They have a cumulative annual allowance of 5% of the original investment which is tax-deferred. This means that the tax will not fall due until the final encashment of the segment or bond. However, tax would potentially be due on any excess withdrawal over the cumulative 5% withdrawals, and this would happen very quickly with both Lily and Oliver’s school fees due to the annual amounts required and the fact the annual 5% allowance equals just £6,250 each.
Alternatively, the trustees can fully encash one or more segments. This could result in an immediate tax charge but, when using a bare trust for grandchildren, any tax liability will fall on the beneficiary and, with Lily and Oliver both at school, they would probably be non-taxpayers. In addition, perhaps, they have their personal allowance, starting rate band and personal savings allowance available to offset against any gain year on year.
Depending on the bond value when the fees are due, it is possible to use a combination of both methods of withdrawal – thus ensuring Grandad can get the actual amount required.
When considering these trusts, it must be remembered that you are making a potentially exempt transfer of £250,000 if going down the bare trust route or a chargeable lifetime transfer of £250,000 if choosing a discretionary trust route. These both take seven years to fall outside of your estate for inheritance tax purposes and, therefore, if you are considering doing any other estate planning, care must be taken to ensure you follow the preferred order of gifting.