Planning for the tax-efficient payment of school fees

Posted: 04/06/2024

A common question for families who have children at private school (or who are considering this option) is whether it is possible to share the costs of school fees tax-efficiently across the generations. The answer to this is yes, particularly for grandparents, who have a number of inheritance tax options available to them, if they would like to assist with fee payment. This type of planning can help to address the cost of school fees, and any potential increases (such as those anticipated if a future Labour government introduces a VAT charge on private school fees).

Gifts from grandparents

Any gifts, including those made by grandparents for the payment of school fees, may become taxable to inheritance tax (IHT) if the donor fails to survive for seven years (this period would be longer in relation to gifts to a trust: an additional seven years, for a potential total of 14).

There are two particular reliefs and allowances available to mitigate the impact of this direct giving:

utilise all available annual exemptions (currently £3,000 per individual, which means two sets of grandparents could potentially make gifts totalling £12,000 per annum, free of inheritance tax); and
consider whether regular gifts can be made out of surplus income (to which there is no limit, providing the gift is regular, the donor’s standard of living is not impacted, and there is evidence of income and expenditure to confirm that the gift is out of surplus income).

The value of the annual exemption may be relatively small in the context of some school fees, but it is surprising how often individuals do not utilise the exemptions available to them. These exemptions may also allow grandparents to tax-efficiently provide a ‘top-up’ to contribute to any increases where parents are bearing the majority of the costs themselves.

Payments can be made directly to a child’s parents for the payment of school fees and some schools also allow direct payment from grandparents (although not all are able to do so, and this should be checked first). Alternatively, payments can be made into a trust for the benefit of the grandchildren, and this might be of particular use where grandchildren are still very young (or even unborn) and schooling decisions have not yet been made. Payments into trust utilising the above exemptions, and an individual’s available nil rate band will also mitigate potential future IHT.

Trusts

There are also often existing family trusts whose trustees wish to provide for the education of the younger generation of a family, or trusts set up by grandparents, perhaps utilising the exemptions described above, which may now be ready and able to make distributions.

Discretionary trusts are subject to their own taxation regime and will be liable to income and capital gains tax (where relevant). If the value of the trust fund exceeds £325,000 (or the settlor’s available nil rate band on establishment of the trust, if lower), then IHT will also be payable on the trust’s ten-year anniversaries and on any capital payments out of the trust. A grandchildren’s trust with a balance below £325,000 may therefore be a useful structure.

Where a trust can be used, the trustees could consider the income tax advantages of making payments to (or for the benefit of) minors. Trustees of discretionary trusts are charged to income tax at a rate of 45% (on income over £500) and capital gains tax at a rate of 39.35% on income and gains arising in the trust; however, distributions to beneficiaries are taxed at that recipient beneficiary’s marginal rate of tax. A claim for a tax credit for income tax for any difference may then be made to HMRC. Funding school fees in this way can be very tax efficient where that minor beneficiary has their own tax free allowance (currently £12,570) and likely no other sources of income.

Example:

The trust generates income of £45,000, which is subject to income tax at 45%. The income tax which is charged on this sum is approximately £20,250 (ignoring the annual allowance and assuming all income is taxable at the 45% rate).
Alternatively, the trustees may decide to distribute income of £15,000 to each of three minor beneficiaries (each of which has a full personal allowance available and no other income) to fund school fees. This results in broad terms to an income tax cost of £1,458 (£45,000 less personal allowance of £12,570 x 3 = £7,290 taxed at 20%).

In this way, trustees are able to respond proactively and positively to changing financial circumstances, whilst at the same time maximising tax efficiencies to preserve funds for the future.

Varying an inheritance

Funds inherited from a family member (or other individual) who has passed away could also be administered tax-efficiently to pay school fees. For example, if a grandparent (or other family member, excluding parents) has inherited funds within the last two years from another estate, which has already been assessed for IHT, then a variation of the will or intestacy that gave rise to the inheritance may be possible. This will write-back the gift into the estate that has already been assessed for tax and will remove the seven (or 14) year look-back.

Again, the variation could make gifts to the parents for payment of fees, pay fees outright, or, if circumstances allow, then funds could be settled on trust for the benefit of the minor grandchildren. The trust could then be utilised for school fees, or indeed more generally for the benefit of the grandchildren if a different educational decision is ultimately made.

An educational legacy

Finally, it is always worth considering gifts made in wills and perhaps establishing a family trust for grandchildren and subsequent generations. This is best seen as a back-up to the inter-family giving strategies outlined above and it may be especially appropriate where family wealth is largely tied up in assets, such as property, that cannot be accessed during lifetime. Unlike the alternatives discussed already, legacies cannot usually be factored into family financial planning with much certainty, but these are an important element of a comprehensive family wealth and succession planning strategy.

Whatever happens with school fees, under the current or any future government, well-planned family finances can streamline how gifts are made and fees are funded, and make sure that this is done with tax efficiency in mind across generations.

Our private client team advises a wide range of families on this and other wealth and succession planning concerns and would be delighted to assist with any queries.