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Grand gesture

My wife and I retired last year on good incomes. We have one grown-up son who has two children aged five and eight. He is paying for them to be educated privately and we are keen to pay part of the fees. We have earmarked £50,000 to invest for the children as their living inheritance as we would like to be able to see them benefit from the money. If possible, we would like to receive in the region of £5,000 a year from the investment as this would contribute half of the fees.

We are prepared to accept some risk and would invest in equities. What do you suggest?

A number of factors need to be considered from the details you have given. It seems evident that you plan to give the money to your grandchildren rather than simply pay their school fees yourself. Giving £25,000 to each of the children will create a potential inheritance tax liability as this amount exceeds the annual gift allowance of £3,000. However, so long as you and your wife live for another seven years, the gift will become exempt from inheritance tax.

As you want the money to create income to pay the school fees, you should consider equity-backed investments. An investment of £50,000 will not generate an income of £5,000 from deposit accounts. However, poor equity returns mean that 10 per cent a year will be hard to generate.

In addition, there are unfortunately only a limited number of high-income-producing products that can be held by children. Unit trusts and insurance bonds, both onshore and offshore, can be written in the name of a child but Isas cannot. You will therefore need to take steps to avoid creating a potential tax liability for your grandchildren, as none of the available products are automatically tax-free.

Generally, equity products used for school fees planning need to generate a surplus income to create the flexibility needed to cope with market volatility. Unit trusts cannot satisfy your immediate desire for high levels of income over the short term but some bonds can.

High-income bonds can produce levels of income of 10 per cent but are not completely risk-free. They are usually linked to an index or basket of shares whose performance over the term of the bond will control the capital return.

Providers have created a large variety of capital protection features and comparing them is essential when selecting a bond. Only choose one that you are comfortable with.

To mitigate against inheritance tax, I would recommend you place the bond in an accumulation and maintenance trust. This is a special type of discretionary trust, where the trustees have discretionary power as to the distribution of income and capital and no one is entitled to it as of right.

For the trust to qualify, one or more of the grandchildren would have to receive a right to at least the income from the trust by the time they reach 25. Until such time, income and gains would be subject to tax at 34 per cent. As the income is to be distributed to your grandchildren, they might be able to reclaim the tax.

The trust would also enjoy favourable inheritance tax treatment in that, if one or other of the children were to die before attaining an entitlement to income, there would be no inheritance tax charge.

Ordinarily, before the children gain their interest in possession, the trustees must either accumulate the income and add it to the trust capital or they must use the income for the children&#39s maintenance, education or benefit. As the income is to be used to pay school fees, a bond would qualify in the trust. The beneficiaries must also either have a common grandparent or the trust must not last for more than 25 years, which is also the position for your case.

Normally, any income received by the trustees is chargeable on the trustees at 34 per cent. Any income paid to beneficiaries who are under 18 and children of the settlor is treated as the settlor&#39s own income for income tax purposes. As you are the children&#39s grandparent, this would not apply. Where income is paid to beneficiaries, it is deemed to be after deduction of tax at 34 per cent and comes with a 34 per cent tax credit.

A full repayment of tax paid by the trustees can be claimed where the child is a non-taxpayer and has not used their personal allowance. In most instances, the child will be a non-taxpayer, so an offshore high-income bond paying gross income is likely to be more appropriate than an onshore version.

If you use an offshore high-income bond, the money can be rolled into another product at the end of the term.

It may also be possible for one bond to be held, which can accept top-up investments in the future, should you wish to add to your grandchildren&#39s investment at a later date.

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