Many parents value the standard of education offered by independent schools and will pay for that privilege. Planning for the fee payments can help. Even if the children do not go to an independent school, they could go to university. In this case, the children can end up with a huge outstanding student loan that could be a burden for many years. Planning for these costs can help avoid that situation.
The average fee for a boarding school is £10,753 a term (£32,259 a year) but if the child does not board and attends daily it is £6,043 a term (£18,129 a year).
For a child attending a day school, the average fee is £4,473 a term (£13,419 a year).
In addition, fees have increased considerably over the years and they rose by 3.5 per cent on average last year (source: Independent Schools Council, annual census 2017).
The overall cost could exceed £300,000 (source: Education Advisers Ltd) – and that is just for one child. Without planning ahead the cost would be a huge drain on earned income or lead to a need for borrowing.
In some cases the grandparents can help out and this can be very tax efficient.
In this article, we demonstrate how an international investment bond and segmentation can be used to effectively fund education costs. Of course, the actual costs can vary and are unknown at the outset.
So to pinpoint the actual amount needed, and not draw unnecessary funds, it can be advantageous to use an international investment bond that can drill down the segments to a minimal level.
Case study 1
Tony and Jane Birmingham are both higher-rate taxpayers and wish to make provision for the private education of their grandson, Joshua.
He is going to a very reasonably priced school as a day pupil and annual fees are currently £10,000. We will assume that they will rise by a modest 3 per cent each year.
Josh starts secondary school in five years’ time and will continue there for seven years until age 18.
Tony and Jane expect to remain higher-rate taxpayers and have £120,000 available for investment. Their adviser recommends that they take out an international investment bond, which is to be divided into 12,000 individual segments of £10.
If they simply invested in their own name, and assuming an annual return of 4 per cent a year (ignoring product charges), how would this strategy fare?
This table shows us the amounts required for school fees each year. As fees become payable, Tony and Jane cash in individual segments to cover that need, albeit with tax consequences.
|End of year||School fees||Segments||Encashment value||Initial value of segments||Gain||Tax payable @ 40%||Net proceeds|
When Josh reaches 18 there are 6,399 segments spare, which can be used if the fees increase above the assumption used or growth is less than expected.
But the obvious thing to note is that, although the fees are covered by the encashed segments, Tony and Jane will have a tax liability. They could pay this out of other resources or increase the number of segments encashed to produce a net amount equal to the fees payable.
At the end of year 5, for example, they would have to encash 982 segments as opposed to 892 to account for higher-rate tax on the chargeable gain.
But is there a better way of doing this? Can they avoid the total tax bill of £13,139? The answer is yes, so let’s look at an alternative strategy.
An alternative strategy
It starts in the same way: Tony and Jane invest £120,000 in an international investment bond, which is divided into 12,000 individual segments of £10.
But then they transfer the bond into an absolute (bare) trust with Josh as the beneficiary and his parents, Mark and Alison, as co-trustees. This is to ensure continuity if anything happens to Tony and Jane.
It will be a potentially exempt transfer (PET) for inheritance tax purposes of £60,000 each — we will return to that later.
When fees become payable the trustees surrender individual segments. Now, as the bond is under a bare trust the gain is assessed on Josh, who is a non-taxpayer, being a schoolboy without any earnings or investment income.
The gain is offset against his personal allowance – which is currently £11,500, but presumably will be higher in five years’ time. He also has his £5,000 starting rate for savings income band and the £1,000 personal savings allowance, both of which can be used to mop up international investment bond chargeable gains. This means that their £13,139 tax bill is avoided.
At age 18, Josh will be entitled to the remaining segments in the trust fund (if any) and can use them for his own purposes. He could then put them towards the cost of going to university, for example.
Death of a donor
What would happen if Tony or Jane died before Josh completed his education? The reassuring thing is that, because the bond is held in trust, the money for the school fees will be there, whatever the position of the estate and its distribution.
If they died within seven years of the trust being established, the PET would fail and there would be a chargeable transfer registered against the death estate. If they had done no other estate planning, the effect of this at the first death would be to use up £60,000 of the deceased’s nil-rate band and reduce the available transferable nil-rate band by 18.4615 per cent (assuming a nil-rate band of £325,000).
What if the parents are paying?
As we have seen, having generous grandparents and an absolute trust can work wonders when funding school fees.
But what if it is the parents who are meeting the bill? Using an absolute trust has no advantage because any chargeable gains would be assessed on Mark and Alison because of the anti-avoidance parental settlement rules in section 629 of the Income Tax (Trading and Other Income) Act 2005.
Although conversely, the transfer will be exempt from inheritance tax because of the dispositions for maintenance of family provision in section 11 of the Inheritance Tax Act 1984.
They could use the 5 per cent tax-deferred allowance, of course — but, looking at the example above, this would run out by the end of year 8 and the withdrawals would come back to haunt them (tax-wise) when the bond was finally encashed.
Perhaps they could just bite the bullet and fund the fees net of tax on the chargeable gains? This could be worthwhile, especially if one of them is a non-taxpayer, but it would depend on their tax position and the other tax-effective strategies that they could use.
Funding university costs
The strategy of using an international investment bond and washing out the chargeable gains using the student’s available allowances can also work perfectly well for funding the costs of university.
In addition, it can be tax effective for the parents because use can be made of bond assignments to shift the tax point to the student.
The expected cost of school fees can be frightening, but with effective financial planning it can be mitigated. The use of trusts and the tax profile of international bonds can be very useful in this regard.
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