The latest tax reforms to investment income have opened up some useful planning opportunities for children’s investments. What is more, the new dividend allowance due to come in next April will provide some others.
In some ways nothing much has changed with investments that are derived from parents’ resources. If the income from a parental gift comes to more than £100 a year it is aggregated with the parent’s own income. But if it comes from elsewhere – grandparents or other relatives or friends – it will be taxed as the child’s income. The child will then have his or her own personal allowance, savings rate, basic rate band and so on.
Junior Isas, or Jisas, are the standard answer for parental investments for children. Offshore bonds in trust make sense for substantial gifts that roll up more or less tax-free until a child is 18, at which point the income will no longer be aggregated with the parent’s. The personal allowance has been substantially increased over the past few years and is now £10,600, moving to £11,000 in 2016/17. That represents a very fair amount of investment income that can be paid tax-free for a child’s benefit. At 3 per cent gross interest an investor would need a capital sum of more than £350,000.
And then there is the zero per cent savings rate that started in April and means the first £5,000 of savings income is tax-free to the extent that it is not covered by earnings. So if the child has a significant level of earnings, maybe as a child star, and it exceeds £10,600 this year, their savings nil-rate band will be affected, but they should still qualify for some provided their earnings are less than £15,600 (£10,600 + £5,000).
Meanwhile, there is the new savings allowance that means an extra £1,000 of savings income is tax-free from next year (£500 for a higher rate taxpayer, and zero for an additional rate taxpayer). This might not be a key issue for many children on a regular annual basis. However, the increased amount of savings income that can be taken tax-free should make a difference to the encashment of offshore bonds.
Quite why offshore bond profits should be treated as savings income is not entirely obvious, but the fact is they are. So the scope to take significantly more tax-free profits could be very valuable. Offshore bonds are often placed in trust for children by their parents and others. The trustees assign the bond across to the beneficiaries who cash it themselves, typically some time after children reach 18 and, as adults, are taxed independently over gifts derived from parents.
Then the tax payable on cashing in will depend on the beneficiaries’ tax position in that year. Get the timing right and it could be tax-free or taxed at relatively low rates on average. Get it wrong and the tax bill could be less attractive. Remember, top-slicing does not apply below higher rate.
It is generally a good idea to cash a bond in a year of low income to make sure as much of the profit as possible is covered by the individual’s personal allowance and basic rate band. But if the level of income from the individual’s earnings and other savings income is below the amount of the personal allowance, some £5,000 could be free of income tax.
Next year there will also be the new dividend tax. For most children the difference will be more apparent than real. Advisers might feel less inhibited about recommending equity investments where a child’s income falls within the personal allowance. Dividends will no longer carry a tax credit; so there will be no question of ‘wasting’ it on income that would in any event be tax-free.
And there might be more of a push to use up the child’s dividend allowance; the first £5,000 of dividend income that is to be taxed at nil. Dividends covered by the personal allowance can be added to this figure, so up to £16,000 of dividends could be tax-free.
The good news about the new dividend tax is the first £5,000 of dividend income will be tax-free even for higher rate and additional rate taxpayers. The bad news is once the allowance is exceeded, all taxpayers including those on the basic rate will have to pay an extra 7.5 per cent tax on dividends.
So if a parent has made a gift to a child and the income is therefore aggregated with their own, next year they may be able to take advantage of the tax-free dividend allowance of £5,000 if they have not already used it up themselves. This tax year £5,000 dividend income of the child of a higher rate taxpaying mother would be taxed at 25 per cent – £1,250. Next year that would be nil, assuming the mother had no dividend income of her own.
Danby Bloch is chairman of Helm Godfrey