Investment bonds are all about giving choices and being able to meet your client’s needs and goals.
Let us consider Stephen and Sarah who have been talking about sending their children to a local private school but, having realised that the average fee is £4,473 per term, know that paying for this privilege will be difficult. Stephen’s parents, John and Elizabeth, would like to give their two grandchildren, aged one and five, the best start in life.
John and Elizabeth have £500,000 to invest and, after considering various options, their professional adviser recommends an onshore bond. To ensure longevity he suggests that the two grandchildren are additional lives assured. In order to give as much flexibility as possible, the bond is set up with 500 individual policies each with a premium of £1,000 which at outset is transferred into a discretionary trust.
With a discretionary trust the trustees decide who should benefit and when, so the adviser suggests that Stephen and Sarah are appointed as additional trustees, as they are aware that the investment is intended for school fees. The transfer into the discretionary trust is a chargeable lifetime transfer but, as John and Elizabeth have not made any previous transfers, each can gift £325,000 before there is an immediate tax charge.
Therefore, as each is gifting just £250,000, there is no immediate inheritance tax charge. Under the bond, the trustees have the ability to take partial withdrawals each year of up to 5% of the amount invested; this can occur for at least 20 years without triggering an immediate tax liability. This means that £25,000 can be withdrawn each year and, if used properly, this facility can give access to regular or one-off payments with minimum administration.
The trustees set up termly withdrawals to coincide with the eldest grandchild starting private school in September. In the first year £13,419 is withdrawn but, as this is within the 5% tax-deferred allowance, there is no immediate tax liability. These withdrawals are distributions from the trust but, as no inheritance tax was payable when the trust was set-up, there will be no exit charge on the distributions under the relevant property regime.
If we assume that the school fees rise by a modest 3.5% each year, when the youngest grandchild starts private school in the fifth year of the bond, the trustees will require yearly withdrawals totalling £30,798. However, with the cumulative tax-deferred allowance the trustees can only continue to fund the school fees within this allowance until year ten.
In year ten the adviser informs them that, when the grandchildren are 14 and 10 and the school fees are £36,579, if they continue to take the withdrawals across all individual policies at the end of the policy year a chargeable gain of circa £8,292 will occur. The trustees are surprised to find out that John and Elizabeth would be liable to any tax. However the adviser confirms that, as both are basic rate taxpayers, even though a chargeable gain will occur, at the end of the policy year there will be no tax to pay. This is because when the chargeable gain is added to their income it doesn’t take them into the higher rate tax bracket, which means there is no further tax to pay, as an onshore bond carries a 20% tax credit.
The trustees continue to take withdrawals in excess of the 5% tax-deferred allowance for the next four years and, as both Elizabeth and John continue to remain basic rate taxpayers when the chargeable gain is added to their income, there is still no tax to pay. By being able to take the withdrawals across the whole bond allows the 500 individual policies to remain intact.
The adviser also informs the trustees that a periodic charge calculation is required on the tenth anniversary of the trust. A periodic charge will arise if the value of the trust fund, plus any distributions made in the previous ten years, is greater than the current nil rate band. At the tenth anniversary the value of the trust fund is £417,860.44, and £221,713.55 has been distributed to beneficiaries in the previous ten years. The total value £639,573.99 exceeds the current nil rate band (£400,000), meaning that a periodic charge would be payable. However, the trustees are pleased to find out that, as there are two settlors, the discretionary trust has two settlements each having its own nil rate band – meaning that there is no periodic charge.
Also, as the value of each settlement is less than 80% of the nil rate band (£400,000), the trustees have no reporting requirements. In year 14 the eldest grandchild, on leaving private education, starts a three year degree course at Bath University. University tuition fees in England and Wales can be as high as £9,250 each year and the trustees would like to continue to use the bond to support both grandchildren.
However, as both Elizabeth and John have now died, their adviser informs them that further chargeable gains would now be assessed on the trust at the trustees’ rate of tax (45%), meaning that the trust would have to pay an additional 25% tax. Furthermore this would mean that the trust would need to be registered with HMRC under the trust register service.
The trustees are pleased to find out that it is possible to move the tax point of any chargeable gain to the grandchildren. To enable this, before fully surrendering any policies, the trustees must first appoint these policies into a bare trust for the two grandchildren. Now, as the policies are under a bare trust, the gain is assessed on the grandchildren and, as both are non-taxpayers, there is no immediate tax liability.
Over the coming years the trustees fully surrender further individual policies to pay for the grandchildren’s education, remembering each time to appoint the policies into a bare trust before surrendering. As no periodic charge was payable at the tenth anniversary there is no exit charge on these distributions.
What has been achieved?
An onshore investment bond offers a simple and straightforward, tax-efficient investment solution for those looking to invest a lump sum for school fees planning. In this case study, John and Elizabeth have been able to assist with their grandchildren’s private education with no, or relatively little, tax applying to the gains made. But one point is notable: the fact that the trustees needed the help of a professional adviser throughout, to ensure that they made the correct choices.
Kim Jarvis is a Technical Manager at Canada Life. She has worked in the life industry arena for over 20 years, with experience in trusts and their taxation, product development, the impact of new legislation on the industry and delivering training. She is an affiliate of the Society of Trusts and Estate Practitioners and a Chartered Insurer.