The average annual cost of private school fees in 2022 in England and Wales was assessed by the Independent Schools Council to be £14,940 for day pupils and more than double that for boarders. It’s not surprising that many parents who feel that private education is the only option for their children are turning to their own parents for help in meeting those costs.
Private school fees paid by parents for the education of their children are generally exempt from any inheritance tax consequences.
However, the same does not apply to provision made to fees paid by grandparents. These will be regarded as a gift to their grandchild for tax purposes even if made directly to the grandchild’s school. Careful consideration needs to be given, therefore, as to how grandparents who are paying their grandchildren’s school fees can do so in a tax-efficient way.
Here are some of the things you may need to consider.
Making ‘pay as you go’ contributions to school fees
Gifts made to individuals are not immediately liable to an inheritance tax charge, but they may become liable retrospectively if the person making the gift dies within seven years. There are exceptions to this, where the gift falls within certain exemptions.
These include the annual gift exemption of £3,000 which everyone can give away each year without risk of any inheritance tax liabilities. The exemption can be carried forward one year if previously unused.
This means that two grandparents using their exemptions for the first time can gift £12,000 between them initially and £6,000 in each subsequent year. A further useful exemption for grandparents relates to surplus income. If income exceeds outgoings, then regular gifts can be made out of that surplus without any charge to inheritance tax.
It’s very important, however, to keep an accurate record of the gifts made and calculations showing the surplus income. These have to be given to HMRC after grandparents have died. Increasingly, HMRC are applying the rules more strictly to ensure that the relief is not abused.
What happens, however, if grandparents do not have surplus income to ‘pay as you go’ for school fees on a yearly basis but would still like to contribute to their grandchildren’s education? As in all areas of life, it can pay to plan early and to start putting aside funds as soon as grandchildren are born.
Using trusts to plan ahead for grandchildren’s education
This may involve regular gifts to the parents within the exemptions mentioned above or a larger lump sum given in the hope of surviving for seven years. This poses a risk if parents divorce in the meantime – or are perhaps tempted to dip in to the funds for other needs.
A better approach may be to create a trust for the grandchildren concerned. There are different types of trust that can be set up. For grandparents with concerns about their own inheritance tax liability but who have a desire to help with their grandchildren’s education costs, there is a clear opportunity to address both issues together.
The tax treatment of various types of trusts can be complicated. It’s important to take proper advice about the investment of the trust assets and the trust structures in which assets may be placed so that best use can be made of the children’s own income and Capital Gains Tax allowances. This helps to mitigate the impact of taxation on the income and gains released on the trust assets.
The use of a trust provides you with an opportunity to tax plan, provide benefit to your grandchildren but ultimately retain an element of protection and control over the trust assets. There are different types of trusts with varying purposes and tax implications.
Looking at the basics, a trust is created by a ‘settlor’ who settles assets into the trust. These assets could comprise property, cash, shares etc. The assets are held and managed by the ‘trustees’, in accordance with the terms of the trust and for the benefit of the ‘beneficiaries’.
It is often the case that a discretionary trust is the trust of choice when assets are being held for the benefit of grandchildren. The nature of a discretionary trust is that there is a class of beneficiaries, none of whom are entitled to benefit from the trust assets until the trustees decide to benefit them.
The beneficiaries will only benefit when the trustees have exercised their discretion in their favour. By using a discretionary trust, it allows the trustees (which could be the ‘settlors’) to consider the circumstances of each beneficiary and to make decisions as to how or if they benefit.
This means their decisions can change to adapt to the circumstances of the beneficiaries throughout their lifetimes. Therefore, the assets in the discretionary trust can be protected against potential future events such as a beneficiary’s bankruptcy, divorce or change in personal circumstances.
The tax implications of discretionary trusts
When considering setting up a trust, consideration of tax implications is required. The rates and allowances vary according to the type of trust and how the beneficiaries stand to benefit.
With regards to a discretionary trust in particular, one of the considerations should be that this is a lifetime chargeable event for you as the settlor. This means that the gift of assets in trust could be immediately subject to inheritance tax if the value gifted exceeds your nil rate band – currently £325,000.
If the value of assets being settled is within the settlor’s nil rate band, there is no immediate inheritance tax to pay. After seven years of settling the asset in trust, the value of this will fall outside the settlor’s estate for inheritance tax purposes. If there are two settlors (i.e., a pair of grandparents) two nil rate bands will be available.
However, if the settlor retained a benefit in the assets settled in trust, for example by living in a property held in trust without paying the equivalent of rent, this would be considered for tax purposes as a ‘gift with reservation of benefit’. This means that the gift is not fully given away because the settlor (person making the gift) retains some benefit – in this example living in the property rent-free.
Retaining benefit would mean that the value of the asset would not fall outside of the settlor’s personal estate for inheritance tax purposes. There would therefore be no benefit from an inheritance planning perspective. This is one consideration amongst many to take into account prior to setting up a trust. Further consideration is required in relation to inheritance tax, as well as income tax and capital gains tax and advice would be specific to you, your estate and the assets you are considering placing in trust.