Investing for Children – Which Options Are Best? (Part 2)

Having given due consideration to the strategies in Part 1, let’s now consider other tax effective investments to help children with the costs of higher education.

Trust Arrangements

In cases where the donor is confident that the child will have a mature disposition at age 18, a bare trust based investment will offer maximum tax efficiency.

Where more control is required over the investment so that there is, in effect, a “wait and see” approach before the child benefits at age 18, a discretionary trust may be more appropriate.

We will now look at these in more detail. Clearly, in either case, the underlying investment should be made to achieve maximum tax efficiency within the constraints of the required investment parameters.

It is not generally legally possible (although certain life policy exceptions do exist) to make outright gifts of assets to minor children and obtain a valid legal discharge. Indeed, it is not often advisable from a practical standpoint. For this reason trusts can be used effectively.

Two options exist:

Bare Trust

Here the donor could consider an investment into a collective investment (unit trust or OEIC) held subject to a bare trust for the absolute benefit of the child.

The advantages of this structure would be:


Where the grandparent is the donor, income will be taxed as the grandchild’s. It is likely that the grandchild will be a non-taxpayer. This means that where dividend income arises, recovery of the tax credit on those dividends will not be possible and so, if this is of importance, an investment in corporate bond funds could be considered.

These generate interest distributions which are paid under deduction of income tax at 20% and this can be recovered by or on behalf of a non-taxpayer.

Alternatively, an investment in an offshore corporate bond fund could be considered. Here interest is paid 
gross and so this will avoid the need for a reclaim of tax.

In cases where the parent is the donor of a bare trust for the benefit of his/her minor child who is unmarried and not in a civil partnership, then if the gross income on investments within the trust exceeds 100 gross in a tax year, it would be taxed on the parent. Therefore, if the parent is a higher rate taxpayer, it may be appropriate to invest in low yielding investments and concentrate an achieving capital growth.

Capital growth

Capital gains will be taxed on the child so this could be a useful way, through careful investment management, of using the child’s annual CGT exemption of 10,100 (tax year 2010/11).

Moreover, the annual exemption is not restricted according to the number of trusts created by the same settlor. Any gains that exceed the annual exemption in a tax year will probably only be taxed at 18%.

Where investment funds are held in a bare trust and being invested to assist with the future payment of university costs, the collective investment could be gradually encashed over three or four years. The child could draw down on the investment from age 18 and, provided capital gains fall within the annual CGT exemption, in effect enjoy a tax-free stream of capital payments.

Another investment that could be held in a bare trust is a single premium bond. H M Revenue and Customs now takes the view that where chargeable event gains arise on single premium bonds heldsubject to a bare trust, they should be taxed on the beneficiary.

The exception to that is in cases where the beneficiary is the settlor’s minor unmarried child not in a civil partnership where the “100 rule” applies (ie. if gross income exceeds 100 in a tax year, it is taxed in full on the parental settlor). However, this rule doesn’t apply with a grandparent settlor or a parental settlor once the child attains age 18.

Therefore, if full policy/segment encashments are made from a bond, chargeable event gains may well count as the child’s income and so, provided the child is not a higher rate taxpayer, in effect provide a series of tax-free payments.

To facilitate some tax-free encashments to fund the costs of pre- university education the 5% (tax-deferred) annual allowances could be used in the knowledge that on eventual encashment after the child had attained age 18, a tax charge is unlikely to arise. Of course, tax (while important) should not be the only determinant of underlying investment strategy.

Investors should always aim to strike an appropriate balance between investment suitability and tax efficiency – ideally achieving both.

Gifts to bare trusts are PETs and so no immediate IHT would arise. Indeed, they will be totally free of IHT if the donor survives for 7 years.

Discretionary / Flexible Trust

A discretionary trust would give control to the trustees to determine who should benefit from the gift and when. This means that if the child does not have a financial need at age 18 or is not responsible enough to receive cash at that time, the release of benefits could be held back until a later date.

Aside from the 1,000 standard rate band, trustees of discretionary trusts are charged to income tax as if they are additional rate taxpayers. Since 6 April 2010, the tax rates on income above this band arising to discretionary trustees are 50% (42.5% on dividends) regardless of the trust’s level of income.

This means that in cases where a grandparent is the settlor, it may be appropriate for the trustees to distribute income to a grandchild beneficiary who is a lower or non-taxpayer in order to recover the additional rate tax paid by the trustees.

Indeed, in these circumstances an interest in possession trust that gives the grandchild a vested right to income but with the trustees having the power to appoint capital may be attractive as this will avoid the beneficiaries having to recover income tax that the trustees have already paid.

In cases where the settlor is the parent of a minor unmarried child beneficiary, it should be noted that 
the “100 rule” can apply. This means that if more than 100 of gross income in a tax year is paid out of the trust to the minor child beneficiary of the settlor, it will be taxed on that parental settlor.

Another planning point to consider, where appropriate, might be to trigger the “settlor-interested trust 
rules” by including the settlor’s spouse in the class of beneficiaries. This would result in the income being assessed on the settlor which would lower the tax rate provided the settlor is not an “additional rate” taxpayer.

Two types of investment may be appropriate for the trust.


If income was not to be distributed it would generally, from a tax standpoint at least, be best for the trustees to invest for capital growth, for example in collectives. This will enable them to use their annual Capital Gains Tax exemption, which is normally 5,050, with excess gains only taxed at 28%. However this investment strategy may introduce an increased level of risk into the portfolio.

Should an adult grandchild have a need for cash at or after age 18 in circumstances which would mean the trustees would have a likely CGT liability, the trustees could make an absolute appointment of benefits to the grandchild and claim CGT hold- over relief. This would mean that the gain would effectively be transferred to the beneficiary, who would have his full annual CGT exemption (10,100) to offset against 
any capital gains that arise on subsequent encashment.

Investment Bonds

Alternatively, (and especially if the settlor-interested trust or gains oriented collective strategies were not possible or appropriate) in order to avoid the high rate of tax that trustees pay on trust income, the trustees could invest in single premium bonds.

In such circumstances, any chargeable event gains (which will include reinvested income within the bond) will automatically be taxed on the settlor if he/she is alive and UK resident in the tax year in question.

Their top rate of tax may well be lower than that of the trustees. Otherwise, chargeable event gains will be taxed on UK resident trustees at 50%, with a 20% tax credit available in respect of chargeable event gains arising under a UK bond.

A UK single premium bond could thus be a particularly tax attractive investment where there is a desire to invest for growth from reinvested income rather than capital gain.

In cases where the trustees wish to encash the bond to realise cash to make a payment to an adult beneficiary to fund university costs or assist with a mortgage or wedding costs, thought could be given to making an appropriate appointment of capital, and then the trustees assigning the bond to that adult beneficiary.

That would not in itself trigger a chargeable event but future chargeable event gains on encashment of the bond will be taxed on the beneficiary at his/her tax rate which will hopefully be lower than the rate paid by the settlor/ trustees.

Gifts to discretionary trusts are chargeable lifetime transfers but an immediate IHT charge would only arise if the settlor exceeded his nil rate band (on a seven year cumulative basis).

Whilst ten-year periodic charges can arise, these are only likely to be an issue if a substantial amount was being placed in trust which is fairly unlikely in these cases.

The Financial Tips Bottom Line

Children will need help in later life to meet a number of financial commitments – be it university costs, assistance in buying a house or funding the costs of a wedding. All of these costs can be expected to increase in the future.

Unless large sums of capital are available, the only realistic way of financing these costs is for a parent or grandparent to set up an advance programme of saving.

The demise of the Child Trust Fund means that Government help will not be available in the future.

All parents and grandparents / guardians need to be aware of tax-efficient investment products and, where appropriate, trusts to maximise the returns available for the child. Where trusts are used, these can enhance tax efficiency and the trust selected can be tailored to meet the parent / grandparent’s and child’s circumstances.

Leave a Reply

Your email address will not be published. Required fields are marked *