In 2023, a new census revealed that the cost of private education in the UK is increasing at its fastest rate in over a decade.
According to the data, parents who choose to send their children to private school are paying an average of £16,656 per year for day school and a whopping £39,000 for boarding school - a 5% increase from last year.
With the rising cost of living making it difficult for many families to make ends meet, let alone pay through the nose for their kids' education, it’s only natural for grandparents to want to help in any way they can, be that through childcare or by providing financial help for paying school fees. The difficulty is that sometimes helping with school fees can have tax consequences, in particular relating to inheritance tax.
In this article, we’ll look at what these tax implications are and explore some ways you might consider (legally!) getting around them.
School fees and inheritance tax: what’s the problem?
You may have heard that inheritance tax (IHT) doesn’t apply to transfers made for the education of children under 18 or in full-time education. While this is true, there are some caveats to this rule.
First up, transfers made for the education of children under 18 or in full-time education are only exempt if they are made by the parent, if the child is in the parent’s care. The exemption does not apply to grandparents, regardless of the circumstances.
So, if you do make a gift intended to cover school fees, these gifts may be counted as part of your estate's valuation and contribute to how much inheritance tax you have to pay.
If you’re a grandparent looking to help with school fees for children under 18 or in full-time education, it’s important to be aware of this to be tax savvy about the financial help you provide.
Tax efficient ways to contribute to school fees as a grandparent
Now you understand the rules about school fees and inheritance tax, let’s skip to the good part. That is, how you can contribute to school fees as grandparents in the most tax-efficient way.
Tax-free gifts
Everyone in the UK gets an annual tax-free gift allowance of £3,000. This means you can give away assets or money up to this amount every (tax) year without them being added to the value of your estate, and therefore subject to inheritance tax.
Theoretically, this means that two grandparents could together contribute £6,000 towards school fees and avoid paying inheritance tax. This is true even if you pass away within 7 years of giving the gift.
It’s also worth knowing that you can carry forward unused annual exemption to the next tax year. So, if you gave no gifts last year, this year you could give £6,000 each, totalling £12,000, which would not be subject to inheritance tax.
But what are your options if you want to give more towards your grandchildren’s school fees?
Making gifts from surplus income
If you can prove that a gift you made during your lifetime was part of your spending routine, it might be exempt from IHT.
But here’s the catch: your gift should come from your spare income, meaning you still have enough to live your usual life after being generous. Also, it has to be a ‘normal’ gift, like something you regularly do, whether it’s a set amount or a regular expense, like school fees.
It’s important to keep a record of these kinds of gifts, as well as keep tabs on your surplus income. HMRC can, and does, ask for these records during probate to ensure the correct amount of inheritance tax is paid on an estate, therefore you must remain transparent about gifts you are making and your income.
Equity Release
Equity release is a financial arrangement that allows homeowners, typically those who are retired, to access a portion of the value tied up in their property. It's a way to turn a part of a home's equity into cash without the need to sell the property.
Using equity release to pay for your grandchildren's private school fees is a possibility. However there are important considerations to bear in mind.
In equity release, the sum released, along with interest, must be repaid. This typically happens when the property is sold, either when you die or if you move into long-term care. Interest rates have risen sharply recently, which when combined with compounding interest could mean the cost of equity release could be much higher in the long term.
Bare trusts
A bare trust is a legal arrangement where a person (the trustee) holds assets for the benefit of another person (the beneficiary).
In this kind of trust, the trustee has legal ownership of the assets but holds them in a minimal (i.e. bare) capacity. The beneficiary has the absolute right to both the capital and the income generated by the assets, and the trustee has no discretion.
Creating a bare trust has some perks. For example, there's no need to worry about certain charges, like entry charges, exit charges, or charges every ten years.
ISA allowances
If you have an ISA, you can leverage ISA allowances. The ISA annual allowance is £20,000. So, if you start saving early in anticipation of contributing to your grandchildren’s school fees you can build up a good amount of money that is tax free. This is because ISAs are exempt from income and capital gains taxes.
An example from Gov.uk demonstrates how a flexible ISA works. Lifetime ISAs are governed by different rules, and you can’t replace what you withdraw.
Example:
Your allowance is £20,000 and you put £10,000 into an ISA during the 2023 to 2024 tax year. You then take out £3,000.
The amount you can now put in during the same tax year is:
£13,000 if your ISA is flexible (the remaining allowance of £10,000 plus the £3,000 you took out)
£10,000 if your ISA is not flexible (just the remaining allowance)
If two grandparents both invest in ISA, £200,000 can be deposited within five years, and as ISAs can build interest, more can be saved following this method.
Discretionary trusts
A discretionary trust provides asset protection should unforeseen life events occur. It will protect your assets in the event of divorce or bankruptcy. Trust assets can also generate additional income to fund school fees.
A discretionary fund is just that. It provides you with the flexibility to choose how much to give to whom. One grandchild might need more support than others with their education.
To benefit from inheritance tax exclusions, you as a grandparent will need to be excluded as a beneficiary of your trust. Each grandparent can deposit £325,000 following this method. And you will minimise the tax paid as payments from a trust for school fees are classed as distributions to the grandchild, and they don’t have to be paid to the child initially, they can go directly to school fees.
Finally, depending on your arrangements, a portion of or the entirety of all the income tax paid by trustees can be reclaimed using your grandchild’s personal allowance.
Trust Funds
If the cost and admin of maintaining a discretionary trust is too high, you can consider a gift of capital made directly to the grandchild. This is called a bare trust. Income generated by the assets held will be the child’s taxable amount, however, the grandparents or parents will retain full control of the funds.
If there are any funds remaining in a bare trust by the time the child turns 18, they will belong to them, and they can take full control at this point if they want.
Gifts
You can give up to £3,000 as a gift every tax year, so with two grandparents you can contribute £6,000 a year towards school fees. HMRC refers to this as an annual exemption, it can be given to one grandchild or several different people.
Of course, the annual exemption is small in the grand scheme of things when thinking about contributing to grandchildren’s school fees, however, this tax-free method is often overlooked and can be worthwhile, especially if more than one grandparent commits to this method.
Moreover, if you didn’t make use of your annual exemption in the previous tax year you can make use of it the next time you do give a gift.
This means that by carrying over the exemption from the previous grandparents can contribute £12,000 between themselves in the first year and £6,000 jointly in each subsequent year.
'Pay-as-you-go’ contributions
‘Pay-as-you-go’ contributions can be made when grandparents have surplus income. This is the case when your incomings exceed your outgoings, you may still be working, or earning money from investments, if you’re fortunate enough to be in this situation you can make regular gifts that are exempt from inheritance tax.
It’s important to remember, however, that you’ll need to keep thorough records of the gifts you make each year. These must be given to HMRC after you and your partner have died. HMRC is clamping down on gift exemptions to ensure that this facility is not abused.
If you don’t have surplus income now, you can still contribute to your grandchild’s school fees. It’s best to plan early and discuss with your children whether they intend to send your grandchildren to a fee-paying school. If you know they will, then you can save towards schooling as soon as your grandchildren are born, or you hear the good news of a grandchild on the way.
Pensions
If you weren’t aware of the recent changes to pension law, in April 2015 changes made to legislation gave greater flexibility to personal pensions.
Now funds can be accessed from the age of 55 and 25% of your pension fund can be used as tax-free cash. Different options are available for withdrawing a sum from your pension fund.
It’s worth knowing that withdrawing pension funds is not the best solution for everyone looking to fund their grandchildren’s private schooling. Keeping funds in an inheritance tax-free environment like a pension fund can be an advantage in the long term.
Get help with estate planning at Lawhive
If you need any help with estate planning and inheritance tax, particularly the implications of making a trust or a gift, get a free case assessment and no obligation quote today to see how we can help.