Why invest for children?
Parents and grandparents have tried to provide a financial boost for their offspring for many generations – it’s part of our DNA. Today, the need has never been greater: our children are facing a perfect storm of financial adversity.
In contrast, those who are grandparents today have enjoyed a generally favourable environment for accumulating wealth.
Here are some of the issues:
1) High cost of further education
Following the recent rise in university tuition fees, UK students now graduate with the highest levels of debt in the English speaking world.
2) Property prices have never been so out of reach
In London the house price to earnings ratio is now over 9, compared with less than 3 in 1991. First-time buyers typically get onto the property ladder at 32 years of age, and nearly half of which have a mortgage of 30 years or more. Were it a corporation, the ‘Bank of Mum and Dad’ would now be the 1oth biggest UK mortgage lender!
3) Much lower employer contributions to pensions
Compared to the generous final salary schemes of the past, employers contribute less than half as much into pensions today.
Why start early
Even small amounts tucked away can build up a substantial nest egg, so the sooner you start putting money away for your child, the better.
One of the key messages is: start early.
The power of compounding (even when returns are lower) means that £1 saved today should be worth much more in the long term.
Choosing your approach
As most children are non-taxpayers, they are likely to be better off by investing in a child savings account at a bank or building society. However, there are options for both investing and saving, and we’ll help you decide which is best for you and your child.
Investing in your own name
One of the simplest ways to start saving for children is to keep the funds in your own name. This gives you total control over when and how the money is accessed. If you are concerned about how the child will use the money or think they might need access before they are 18, then this could be the best solution. The downside to keeping the investment in your own name is that you cannot make use of the child’s tax allowances so you will be personally responsible for any tax due.
If you don’t use your own ISA allowance every year, then it makes sense to use this tax shelter first. If you are already using your ISA allowance you may also have your Dividend Allowance and Capital Gains exemption available.
With this approach it is worth making a longer term plan to dispose of assets in a timely fashion, as any investments left in your name when you die (plus any gifts given away in the previous seven years) will be subject to Inheritance Tax (IHT).
Investing in their name
Something to consider is that the child will have complete access to the money once they are 18 years old, and as such you will have to be confident in their pendent financial responsibility.
Children have the same personal tax allowances as adults, so there is not usually any tax to pay on their investment income or capital gains.
The exception is the ‘parental settlement’ rule. If money gifted to a minor child generates more than £100 of interest in a year, then the parent must pay the tax due on this. So, if a parent gives a child £4,000 and they receive 2.5% interest a year, then the parent will have to include the tax as part their own income. This rule doesn’t apply to other relatives, such as grandparents, and is intended simply to prevent parents from using their children’s tax allowances to avoid paying their own tax.
Selecting an investment strategy
In almost all cases an investment for a child implies a long timescale. It also usually involves regular contributions rather than a single lump sum.
This situation is ideal for adopting an adventurous investment strategy, where you accept the greater volatility that comes with the potential for greater returns in the long term.
Fluctuations in stock market values can be advantageous to regular investors as a result of the phenomenon called ‘pound cost averaging’, whereby your money buys more when markets are depressed.
This all suggests that a child’s portfolio should be invested largely in equities (shares in companies) and property, since these are the types of assets that, historically, have produced the highest returns, over the long term.
Cash savings
If you will be saving for less than five years, then a cash deposit is likely to be the best option for you.
In comparison to standard deposit rates, there are some attractive interest rates available for children’s accounts, but the amounts you can pay in are usually relatively small.
Despite the attractive savings rates available to minors, saving in cash over a longer time doesn’t make sense. Unless the interest rate you receive on deposits is higher than the rate of inflation, then the value of your money is reduced.
In recent years interest rates have been very low, which has meant the purchasing power of money in bank accounts has been reduced over a 10 year period. If you’re investing over an 18 year period, the returns from a bank account won’t keep up with inflation.
Premium Bonds
Rather than a fixed rate of interest, Premium Bonds allocate interest via a monthly lottery.
The total monthly prize fund is based on an assumed interest rate of 1% and the odds of each bond winning a prize in any month is 34,500 to one. The more bonds you hold each month, the more chance you have of winning, but in any month many people won’t win anything at all. Prizes are tax-free, which means that premium bonds are a better option for higher or additional rate taxpayers. And as Premium Bonds are backed by the government, they are very safe investments.
However, all bank accounts are now guaranteed up to £85,000 per institution via the Financial Services Compensation Scheme, so for many there is little advantage to Premium Bonds from a risk perspective.
Junior ISAs
One of the most popular ways to save for children is to open a Junior ISA (JISA). These are tax-free savings accounts that allow you to save up to £9,000 each year in a cash deposit or by investing in stocks and shares. There is no tax to pay whilst the money grows inside the JISA account, and all withdrawals are tax free.
JISAs are a simple way to save for a child’s future – there are lots on the market to choose from and they are usually easy to open, either by depositing a lump sum or setting up a direct debit. Parents or guardians need to open the account, but once open anyone can contribute.
The Junior ISA is the successor to the Child Trust Fund (CTF). If your child already has a CTF then you have the option either to keep it and continue to make contributions, or to transfer the CTF into a JISA. You cannot hold both.
Junior ISAs offer a number of advantages over CTFs, including more choice in the market, access to a wider range of investments and lower fees.
There are two disadvantages to using a JISA:
- The money belongs to the child, who can’t withdraw it until they are 18. You cannot get back the payments once they have been made
- Once the child turns 18, they have unrestricted access to the fund.
If you are confident your child will use the money to fund their education and put down a deposit on their first property, then this will give them a great start in life. However, not every child will be this sensible and you cannot prevent them accessing the funds. On their 18th birthday the fund will be converted to a standard ISA in their name.
Bare Trusts
An account owned by a child but overseen by an adult until the child comes of age, is usually seen as a ‘bare trust’, and benefits from favourable tax treatment. A Bare Trust is the technical term for an account that belongs to a minor but is controlled by an adult. A Junior ISA is an example of a Bare Trust.
At 18, the child can request access to the whole fund without restriction but up until that time the adult makes the decisions about how the money is invested. Beyond a JISA, a bare trust can usually hold any asset. However normally it forms a selection of market linked investments.
You can also appoint other trustees to help manage the account by drawing up a trust deed. However, there is no requirement to do this, and a simple trust is created automatically when you set up such an irrevocable account. Setting up a Bare Trust can be very effective for grandparents, particularly those looking to reduce the potential IHT bill on their estate.
Except for the parental settlement rule, the child is responsible for any tax.
If you die within seven years of making a gift, then all or part of the value could be subject to IHT. There are two exemptions which are relevant if you are contributing to a savings plan for a child.
Up to £3,000 a year can be gifted each year without any IHT liability. If you don’t use this allowance, it can be carried forward to the next tax year, so a maximum of £6,000 can be gifted in this way.
There is a second exemption for ‘gifts out of income’. Provided a gift is part of your normal expenditure and does not affect your standard of living, it will not be subject to IHT. This is particularly useful for anyone setting up a regular savings plan for a child.
If you intend to rely on these exemptions, it is very important to keep accurate records.
It is important to understand that the money will be in the child’s name. When appropriate, discuss with your child how to use the money responsibly.
Using pensions
Bequeathing a pension is one of the most effective ways to provide financial help for your children or grandchildren. Pension freedom rules have made it much easier to use your pension fund in this way.
It is unlikely that IHT will be due on the money left in your pension when you die. Your beneficiaries can decide whether they want to take lump sums or income from the remaining pension. Alternatively, they can leave some or all the fund invested to pass it on to their own children or grandchildren. Pension money can be passed down the generations without any IHT.
If you are under 75 when you die, it will be unlikely your beneficiaries will have to pay any tax on the money they draw from your pension. If you are over 75 then they pay income tax as they draw down from the fund. If you are leaving money to children who do not have taxable income of their own, they would be able to draw up to their Personal Allowance each year without paying any tax.
In contrast, money outside of a pension will be subject to IHT at 40% if total assets are more than the nil rate band. From an IHT perspective, if you have a choice between drawing income from your pension or from other investments, it’s usually better to draw money from the pension last.
If you are paying the maximum into your own pension, you could consider making contributions into a pension for a non-working spouse. Everyone under 75 can receive tax relief on a gross contribution of £3,600, even if they don’t have any employment income. These contributions will benefit from tax free growth whilst invested in the pension and can be left as an IHT free lump sum to grandchildren.
Junior SIPP
Given the huge costs involved in raising a child and early adult life, it might seem strange to pay money to a pension which cannot be accessed for decades when there are many other expenses to worry about. However, the long term tax benefits of pensions plus the Government top-up can make for a compelling case in certain circumstances.
Money put into a pension for a child has longer to grow in a tax-free environment and cannot be frittered away in early adulthood. By contributing the maximum allowed to a Junior SIPP each year for 18 years you could provide your child with a retirement fund of over £400,000, even if they make no other contributions as an adult.
The government encourages pension saving by topping up contributions with an extra 20%. The maximum that can benefit from this uplift is your total salary. Where individuals do not have any earnings, the government will still add tax relief up to a maximum of £3,600. If you contribute £2,880 to a child’s pension, the government will top this up to £3,600.
Other options
For families with a higher income, there are other options for you to invest with more control over your money, and ways to reduce the inheritance tax due on your estate.
Investment Bonds
Sometimes known as an insurance bond, and investment bond is a way of investing that allows tax to be deferred until the investment is encashed.
When the bond is set up, it can be divided into several ‘segments’, each with an equal value. For example, an initial investment of £250,000 could be divided into 100 segments each valued at £2,500. When you encash the bond, income tax is paid on the profit on each segment. If you are a taxpayer, you can assign segments to someone who pays tax at the lower rate than you, to reduce the amount of tax due.
This is helpful for parents or grandparents who wish to retain access to their money, but don’t want to pay any ongoing tax. It’s also possible to draw up to 5% of the initial investment each year as a regular income. There is no tax to pay on these withdrawals as they are accounted for when the bond is encashed.
This can be useful in situations where ongoing payments are required, such as regular payment of school fees.
The amounts withdrawn are added back to the final gain calculation when the bond is encashed. Charges on offshore bonds are relatively high on investments of less than £100,000.
Discretionary Trusts
A Discretionary Trust can be set up for the benefit of a group of people, known collectively as the beneficiaries, rather than one specified person. This is particularly useful for grandparents as the trust can be worded to include any future grandchildren as well as those they already have.
Unlike the bare trusts mentioned earlier, the beneficiaries have no automatic right to access the fund at 18. Instead, the trustees (often parents or grandparents) retain total control over the fund. The trustees decide who benefits, how much they should receive and at what time; there is no requirement to treat all the potential beneficiaries equally.
Because the trustees retain such a high level of control over the funds, gifts into a Discretionary Trust are subject to a different IHT treatment. There is usually no initial tax charge on gifts under £325,000 provided there have not been other gifts in the seven previous years. Once the money is invested the trustees are responsible for any tax arising on the investment, whilst it still owned by the trustees. Trustees usually pay tax at the highest rates with the beneficiary reclaiming some of the tax from HMRC.
If the trustees set up an Investment Bond, there is usually no tax to pay until some or all the bond is encashed. The trustees can also give ‘segments’ of the bond directly to the beneficiaries. If the beneficiary then cashes it in, they pay any tax due at their own tax rate (and not the trustees’ rate). This is particularly useful in cases where the beneficiaries have no other income so pay very little tax.
Investing in property
Many parents will be thinking about how best to help their children get onto the property ladder. Buying a second home for your child to live in might offer you the most control over the investment, but that also comes with the greatest tax liabilities.
Any taxable gain on your property would be subject to CGT at the higher residential property rate (currently 28%) and the purchase would attract a 3% stamp duty surcharge. In addition, the home falls within your estate for IHT purposes. An alternative approach is to either gift or lend money to your child, either to provide them with a deposit or to buy a property outright. Providing the child lives in the property and it is their only home, normal rates of stamp duty would apply and any future gain in value would be tax free. If you live seven years from the date of the gift, then it falls outside your estate for tax purposes.
Parents who are not comfortable in making an outright gift can opt to lend money to their children instead. Reserving the right for the loan to be repaid can protect you in the event of your child breaking up with a partner. If you find that you no longer need the money, the loan can be waived, and the funds gifted at a future date. As a loan, the money will remain part of your estate.
A potential downside is that if your child needs to take out a mortgage, lenders will take the parental loan into account when considering affordability. And if you really need the loan repaying, in practice it might be difficult for your child to repay.
