Niki Patel on planning for the costs of private or higher education
Providing children and grandchildren with either private education or helping them with university costs has become an important factor for many families – after all, having a good education should help boost their financial future. However, with the introduction of university tuition fees and the rising costs of private education, it is inevitable that those wishing to help young ones in this area are likely to need advice in relation to the options that may be available.
Given that fees vary from school to school and area to area, the overall cost can end up being significant. According to the Independent Schools Council (ISC), about 6.5% of children are educated privately in the UK. As a whole, the UK independent sector educates about 620,000 children in around 2,500 schools. The 2021 ISC Annual Census revealed that the average fees per term for pupils at senior boarding schools was £11,784, equating to more than £35,000 a year. Boarding school day fees are about £5,333 per term, so just over £15,000 a year. Overall, even though the majority of pupils attend day schools, the typical fee level is still £5,064 per term, or £15,191 a year. Day school fees also vary by region, with average termly fees of just over £3,700 in the North West, rising to just over £6,000 in London.
Currently, the maximum annual university tuition fee in England is £9,250. Using the University of Kent’s cost of living calculator for an undergraduate living off campus, the annual cost of living, including books, food, clothes, and travelling to and from college is between £12,376 and £22,256. That is between £37,876 and £68,112 for a three-year course, assuming 2% a year inflation.
This cost of living does not include the tuition fees that students are required to pay.
Before putting a financial plan into place, as a starting point there are many factors that ought to be considered,
such as:- How old is the child/grandchild?
- How many children/grandchildren is funding required for?
- How many years need to be funded?
- Which school/university will they attend?
- How much are the fees?
- How much will the fees increase by?
- Are fees payable in monthly instalments? Or termly? Or annually?
Answers to these questions will help put a plan into place, as it will determine how much is likely to be needed and when – and therefore what type of investment may be suitable given the investment term. It is also vital to consider the investor’s attitude to risk, tax position and whether they wish to invest a lump sum or save regular amounts. In many cases, a combination of investments/wrappers may be suitable, based on the overall needs.
It is important to note that payment of school/university fees by a parent for a child who is in full-time education would not constitute a gift for inheritance tax (IHT) purposes. However, payments made by a grandparent would constitute a gift (potentially exempt transfer) for IHT purposes. This means that, for many parents, they could use their existing investments to pay fees without any IHT implications, but they would need to consider any potential income tax or capital gains tax (CGT) implications.
Tax-efficient saving
Individual Savings Account
A tax-efficient way to save would be to open an Individual Savings Account (ISA) and subscribe into it each year.
The current annual subscription limit is £20,000 (so up to £40,000 for a couple), which can be held in either cash or invested in stocks and shares.
It is important to note that only one type of account can be saved into each tax year.
Parents can then withdraw the funds from the account tax-free and use the money to pay for children’s school fees.
As mentioned earlier, payments of school fees made by grandparents will be gifts – potentially exempt transfers for IHT purposes – unless covered by the annual exemption of £3,000.
It is also possible, from the age of 16, for the child to hold a cash ISA, and from 18, a stocks-and-shares ISA. Payments by the parent or grandparent would normally be gifts for IHT unless covered by the annual exemption of £3,000, or by the normal-expenditure-out-of-income exemption.
Junior ISA
While it is possible to set up a Junior ISA (JISA) on behalf of the child and currently save up to £9,000 per tax year, the account belongs directly to the child, who can take control of it at 16 and withdraw the funds at 18 tax-free. This option is unlikely to appeal to those who wish to retain control in terms of when children/grandchildren become entitled to the funds. However, it may be considered by those who are confident that their child will be attending, say, university and will need the funds to support them.
Any payments made into the account will be treated as gifts for IHT unless covered by the annual exemption of £3,000 or by the normal-expenditure-out-of-income exemption. However, it should be noted that any amounts paid by a parent to a JISA for their child will not be subject to the parental settlement provisions (so would not be taxed on the parent if income exceeds £100 gross in a tax year) – please see below for more detail.
Child Trust Funds
While no new accounts can be opened, it is still possible to save up to £9,000 in an existing account. However, the same rules as mentioned above for the Junior ISA would apply in terms of the child/grandchild gaining access at 18, as well as the tax treatment of any payments made into the account. Our technical refresher looks at these accounts in more detail.
Registered pensions
Not a vehicle to be used for school fees planning, as funds will be not available until the child attains age 57 (currently 55). However, pensions provide a way to save tax efficiently for the child, as the contributions are invested in a tax-free fund. It is possible for anybody to provide funds to be contributed to a registered pension plan for a child. The maximum annual contribution is £3,600 gross, with the contribution being paid net of basic rate tax. The £720 basic rate tax relief added by the government each year is a significant benefit and the earlier that pension contributions are started, the more the child will benefit from compounded tax-free returns.
Again, any payments made into the pension will be treated as gifts for IHT unless covered by the annual exemption of £3,000, or by the normal-expenditure-out-of-income exemption.
At age 57 or later, the benefits have to be taken in a particular form but, under current rules, up to 25% of the fund can be taken as a tax-free cash lump sum.
Other investment options
Investment bonds
Parents/grandparents can make a lump sum investment and use the cumulative tax-deferred allowance to pay school/university fees. They can also decide to surrender segments over time to pay the fees. Where such an investment is taken out by a grandparent, any withdrawals taken from the bond to pay school fees would be treated as gifts for IHT unless covered by the annual £3,000 exemption.
Alternatively, the parent/grandparent could assign the bond or segments of the bond to the child/grandchild once they attain age 18. Each individual is taxable in their own right, which means they are entitled to a full income-tax personal allowance (£12,570 for the 2021/2022 tax year). The child/grandchild can then make an encashment and pay tax in accordance with their rate(s) of income tax on any chargeable event gain. Such an assignment will however be a gift for IHT.
Collective investments
Parents/grandparents can invest either a lump sum or regular amounts in a portfolio of shares/unit trusts. Going forward, they can then encash shares/units while making use of their annual CGT exemption (£12,300 for the 2021/2022 tax year) to provide funds to pay fees.
Again, payments made by grandparents will, of course, be a gift for IHT unless covered by the annual £3,000 exemption.
Trusts
It would be possible for a parent/grandparent to set up a trust on behalf of the child/grandchild. Investment bonds and collective investments tend to be a popular choice as trustee investments. This is because a child/grandchild cannot legally hold the investment while they are a minor but, with careful planning, funds can often be extracted from these investment vehicles in a tax-efficient manner.
Nowadays, it is common to set the trust up on an absolute/bare trust basis, or on a discretionary basis.
Absolute trust
With an absolute trust, both the income and capital is held absolutely for the benefit of the beneficiary. This means that the beneficiary will have access to the trust fund at age 18 (age 16 in Scotland).
From a tax perspective, as the income is held absolutely for the beneficiary under the terms of the absolute trust, the beneficiary is normally personally subject to income tax on any income arising. The only exception to this rule is where the parental settlement rules apply, i.e. the donor is the parent, in which case if gross income, including chargeable event gains on bonds, exceeds £100 in a tax year, from all gifts made by the same parent, it is assessed on the parent(s) in respect of any beneficiary who is under age 18 and unmarried, or not in a civil partnership. However, where the trust is settled by a grandparent, the absolute beneficiary would be taxable on any income and could therefore use their personal allowances against any income.
For CGT purposes, any capital gain is taxed on the beneficiary and thus they would be able to use their annual CGT exemption – currently £12,300 – against any gains.
For IHT purposes, the person creating the trust is treated as making a potentially exempt transfer, which would normally fall out of account after seven years.
Example:
Frieda decides to set up an absolute trust for the benefit of her grandson, Oliver, who is nine. She has £300,000 to invest and wishes to use the money to help pay for his private school fees, which amount to £13,200 per annum, but also to provide funds for higher education. His parents require about £7,000 as a top-up to the payments they are currently making.
Frieda has made not made any other gifts in her lifetime but uses her annual exemption of £3,000 each year. Given that the trust is an absolute trust, there would be no lifetime IHT to pay on the gift.
Of the £300,000, £150,000 is invested in an offshore investment bond, which is split into 100 segments, and £150,000 is invested in a unit trust portfolio of 200,000 units yielding 3.5% each year. The cost of each unit is 75p. The dividend income would be taxed on Oliver as he is the absolute beneficiary of the trust.
Oliver would be entitled to benefit from a personal allowance, the starting rate band for savings income, where relevant, the personal savings allowance and the dividend allowance.
In this case, the total amount generated (£7,000) would be covered by his personal allowance so there would be no income tax to pay.
Six years go by and further funds of £7,500 are needed to help with the fees. At that time, each unit is worth 95p.
The trustees decide to encash 8,000 units from the unit trust portfolio. This provides £7,600 (8,000 x 95p), which is more than sufficient.
The capital gain would be £1,600 ((95p – 75p) x 8,000) which is fully covered by Oliver’s annual exemption of £12,300 so there would be no tax to pay.
Another option would be for the trustees to make use of the 5% tax-deferred allowance and withdraw £7,500 from the investment bond.
This would not give rise to an immediate tax charge as it is well within the amount available.
Alternatively, the trustees could consider encashing segments. Let’s say the investment bond has grown to £202,352.
If the trustees were to surrender four segments, this would provide funds of £8,094.08 (£202,352/100 = £2,023.52 x 4).
The chargeable event gain would be based on:
[surrender value of each segment – amount invested in each segment]
£202,352/100 = £2,023.52
£150,000/100 = £1,500
£2,023.52 – £1,500 = £523.52
£523.52 x 4 = £2,094.08
The chargeable event gain of £2,094 together with the dividend income of £7,000 is all within Oliver’s personal allowance of £12,570 so there would be no income tax to pay.
In future years, tax savings can be maximised where the trustees withdraw funds as Oliver’s personal allowance and CGT annual exemption can be used.
Discretionary trust
With a discretionary trust, it is common for numerous classes of individuals to be able to benefit. Therefore, no one has an entitlement to income or capital. Instead, the trustees have full discretion in terms of when to make payments, how much to pay/appoint and to whom.
Trustees of discretionary trusts are assessed to income tax at 45% (38.1% for dividends) subject to the standard rate band, which is usually £1,000. The first £1,000 of income is taxed at 20% (7.5% for dividends). If the settlor has set up more than one trust, the standard rate band is reduced proportionately subject to a minimum of £200 per trust. Where income is paid out to a beneficiary, they are treated as receiving that income with a tax credit of 45%. Note, however, if the settlor and/or their spouse/civil partner can benefit under the terms of the trust, the trust is effectively known as a ‘settlor-interested’ trust, in which case the settlor will then be taxable on all income arising.
If the trustees invest in a bond, any chargeable event gain would be assessed on the settlor while alive and UK-resident.
Home reversion plans enable the homeowner to sell their property or a proportion of it to a home reversion plan provider in order to raise funds immediately
Any capital gains will be assessed to tax on the trustees, normally at 20%, after taking account of the annual exemption, which is usually half that applicable to individuals – currently £6,150 – although if the settlor has set up more than one trust the exemption is reduced proportionately subject to a minimum of £1,230 per trust.
For IHT purposes, the person creating the trust is treated as making a chargeable lifetime transfer. So, if the amount exceeds their available nil rate band, after taking account of any other chargeable lifetime transfers they may have made in the previous seven years, IHT would be payable at 20% on the excess. Given that the trust is discretionary, it would also be subject to IHT exit and ten-yearly periodic charges.
Example:
Pete and Kate are married with two young children, Libby aged eight and George aged six. They have no plans to send the children to private school but decide to put a plan in place to help fund their higher education.
They sold their portfolio of shares, which generated £148,000. Upon sale, they decided to set up a discretionary trust. Neither of them had made any other lifetime gifts, so there was no IHT to pay on creation of the trust. The money is invested in an offshore bond, which is split into 20 segments. They both decide to act as trustees, together with Pete’s brother Paul.
Ten years go by and during this time the trustees have not made any withdrawals from the bond. Assuming a growth rate of 5%, after 10 years, the bond has grown to £241,076. Given the amount is well within both Pete and Kate’s available nil rate band of £325,000 each – so £650,000 in total – there is no periodic charge payable on the 10-year anniversary.
Libby has recently secured a place at Newcastle University. Taking account of tuition fees and her living costs, together with the help of her parents, Libby has worked out that she will require about £23,250 in her first year and slightly more in her second and third year.
Given the current value of the bond, if two segments were surrendered this would provide funds of £24,107.60 (£241,076/20 = £12,053.80 x 2).
The trustees therefore decide to make an absolute appointment in favour of Libby to take advantage of her tax position and assign two segments to her, for her to surrender. Ordinarily, this would give rise to an exit charge for IHT. However, given that no periodic charge was payable on the last 10-year anniversary, there would be no IHT exit charge on the appointment. In addition, the assignment does not trigger a chargeable event for income tax, but tax may be payable upon encashment.
The chargeable event gain on the two segments would be based on:
[surrender value of each segment – amount invested in each segment]
£241,076/20 = £12,054
£148,000/20 = £7,400
£12,054 – £7,400 = £4,654
£4,654 x 2 = £9,308
Libby has no other income, which means the chargeable event gain of £9,308 upon encashment of the two segments is fully covered by her personal allowance of £12,570, so there is no income tax to pay on the gain. Libby can then use the money to pay for her first year at university.
In her second and third year, the trustees can again make an absolute appointment in her favour and assign segments (two or more) to her, for her to surrender. Again, provided she has no other income, she can make use of her personal allowance, the starting rate band for savings income and the personal savings allowance against any chargeable event gains. For the current tax year, this means it is possible for Libby to realise a chargeable event gain of up to £18,570 without incurring an income tax liability.
Similarly, the trustees can also make an absolute appointment to George and assign segments to him once he has attained age 18 and requires funds to help with higher education. Or in the event that he does not go to university, given that the trust is discretionary, the trustees have flexibility to make appointments as and when money is required, so this could, for example, be to provide funds for a house purchase.
Equity release
Parents/grandparents could consider equity release to generate funds to invest to provide funds for private/higher education. The term ‘equity release’ is generally used to describe two products – home reversion plans and lifetime mortgages. These provide a way of releasing the capital wealth built up in the home and in any other properties that the individual may own.
Home reversion plans enable the homeowner to sell their property or a proportion of it to a home reversion plan provider in order to raise funds immediately. Lifetime mortgages work in the same way as any other mortgage, except that the term is open-ended and invariably interest only – this means that the individual does not need to dispose of their home or any part of it. Both of these product types are restricted by lenders to those who are at least 55 years of age or older, although this is not a legal requirement and more a matter of policy.
In most cases, anyone considering this option is likely to choose a lifetime mortgage as it is a debt secured against the home or other property. The mortgage is normally repaid from the sale of the house and interest can either be paid monthly or rolled up so there are no monthly payments to worry about.
Example:
Harry, 63, and Magda, 64, own a property outright that is worth £720,000. They would like to help their daughter, Sally, pay for private school fees for their grandson James, who is 11. The fees are £14,200 per year and have been increasing by about 2.5% each year. If their grandson is in school for six years, they will owe around £90,706.
They decide to arrange a lifetime mortgage, which will give them £14,200 to cover the first school year, and a reserve facility of £95,000 that they can draw down in small amounts to cover subsequent years.
Their daughter has some surplus income each month and has offered to cover the interest payments for them, so there are no payments for Harry and Magda to worry about. Sally ought to keep records of her income and expenses to show that the payments are covered by the normal expenditure-out-of-income exemption – she can record this using the IHT403 form available on the HMRC website: https://bit.ly/3HrgTxz
Finance plans
Some providers offer finance plans which enable parents to make provision for their children’s school fees. These plans enable parents to spread the cost of school fees rather than paying a lump sum each term. Parents effectively borrow money to help fund school fees and are often required to repay those plans with monthly repayments over a number of years.
Summary
As can be seen, there are a number of options available to help fund for children’s or grandchildren’s education. However, seeking advice will be vital for those who wish to plan in this area to ensure that they achieve their overall goals which are in line with their specific personal circumstances.
Niki Patel is a tax and trust specialist at Technical Connection
