Avoid the tax traps when giving money to children

As the cost of living crisis intensifies, shoring up the financial future of your children and other young family members has never felt more important but beware the tax traps

Financial gifts can be an attractive option for parents and grandparents that want family members to have the same opportunities they did, particularly when you consider the mountain of money challenges facing young people right now. From the high costs of a university education to the huge deposits first-time buyers require to secure a home and rapidly rising living costs, young people increasingly need a helping hand to start their life.

While giving a financial gift might seem relatively straightforward, particularly if it is cash, choosing an option that is also tax efficient needs careful consideration. At a time when everyone is contending with high inflation, rising interest rates, diminishing tax allowances and a recession, passing money onto the next generation should never be done at the expense of your own financial security.

The last thing parents or grandparents should do is leave themselves short or trigger an unnecessary and unexpected tax bill that will potentially fall on the beneficiary, so if you are unsure about the tax implications of your gift or whether you can afford it, here is a guide to the tax-friendly financial gifting options this Christmas:  

Cash is the simplest gift but don’t give too much

While giving and receiving cash does not incur a tax bill, if you die within seven years of making the transfer then inheritance tax (IHT) rules will come into play. This applies if the value of your estate exceeds £325,000 at death, with amounts over this limit potentially attracting a tax-charge payable by your beneficiaries.

The good news is that several exemptions apply outside the seven-year rule that allow people to make financial gifts without worrying about a hefty IHT bill. These include:

up to £3,000 can be given away every year tax-free. This allowance can be carried forward for one taxy ear which means up to £6,000 can potentially be gifted in a lump sum free from future IHT liabilities; and the small gift allowance means multiple cash sums of up to £250 per recipient can be given without affecting an IHT liability.

In addition, people can also give money away that comes out of their regular income – a regular payment that does not affect the giver’s standard of living.

Rather than coins and cash, pre-paid cards can be an effective way for parents to give cash to young children as it helps their offspring get to grips with paying by card in this digital era. These cards are often paired with an app so that both the parent and child can track the spending – a useful tool for saving and budgeting – with parents able to set spending limits and monthly allowances. However, no interest is applied – demotivating for a child that wants to save – and most pre-paid cards come with a monthly or annual fee.

Cash gifts can be limiting if parents or grandparents have a vision of how they want the money to be spent, as younger children are likely to focus on short-term wants such as toys and games while young adults might blow the money on a holiday or a night out.

If the giver and beneficiary have agreed on a cash gift so that the money can go towards a big-ticket item such as a new computer, that’s one thing, but if the parent or grandparents want the money to be saved or invested for longer-term needs such as education or a house deposit, then a different strategy needs to be applied.

Open a savings account but be quick as rates may have already peaked

Setting up a child’s savings account – one that encourages them to save their own money and benefit from the compounding effect of interest payments – is a key life lesson that will not only prove invaluable as they progress into adulthood but also boost their chances of having a financially secure future.

Savings rates have improved rapidly in recent weeks with some children’s accounts offering better rates than adult adults. But while rates are at their highest levels in over a decade, the returns are still deeply negative in real terms when you factor in sky-high inflation.

It means parents and grandparents should shop around for the best deal rather than just picking the lender they bank with – and move fast. While the Bank of England’s base rate is currently 3% and expected to rise further to peak at about 4.5% next year, that is significantly lower than the 6% or more expected in the wake of former Chancellor Kwasi Kwarteng’s mini Budget.

That means savings rates may have already peaked, so locking in the best rate now for a set period will certainly pay off particularly if inflation, currently at a 41-year high of 11.1% halves – as it is expected to do – by the end of next year.

Choosing the right savings account depends on factors such as the child’s age, the interest rate, the type of bank card they want and the minimum amount they can have in the account. While some accounts only pay interest on balances up to a certain amount, such as up to £1,000 or £3,000, others offer tiered interest rates with higher rates on lower balances or vice versa.

Remember to carefully assess how much you contribute to a child’s savings account to avoid triggering an unnecessary tax bill. If the child receives more than £100 in interest from money given to them by the parent, then the parent is liable for tax on the interest if it is above their own personal savings allowance. The £100 limit does not apply to gifts given by grandparents or other relatives.

Go big and save up to £9,000 in a Junior ISA

While savings accounts are ideal for teaching young children about money, particularly if they want to save towards a new toy or gadget, for bigger financial goals such as funding a gap year, university fees or a first car, that require larger sums, a Junior ISA (JISA) is a better option. These are tax-free accounts to enable investments or savings to be built up for a child.

While the IHT rules still apply on the amounts donated, up to £9,000 can be saved into a JISA every tax year – with all returns free from tax – allowing parents and grandparents to potentially club together and contribute without the restrictions on the interest that can be applied that come with a savings account.

A child cannot manage the money themselves until they turn 16 and cannot access it until they are 18 – a good restriction for those that want to safeguard the money. At 18, the JISA can be converted into an adult ISA, allowing the child to access a pot of investments or cash they can put towards a car, university costs, a house deposit or leave invested until the right time comes to access the funds.

While many parents choose cash savings for their children’s JISAs, this may not be the best use of a long-term allowance that cannot be accessed until a child is 18 as returns will be negative in real terms after inflation and the child is unlikely to need a JISA to save tax on interest.

Like adults, children have a tax-free personal allowance enabling them to earn £12,570 income a year and a personal savings allowance, which means even basic rate taxpayers can earn up to £1,000 of savings interest tax free as well.

If you are prepared to put money aside for a child for a medium to longer term period, such as five years or more, then a Junior ISA can be used for making investments in the financial markets, with money held over the long-term benefitting from a compounded return that has the potential to beat inflation.

A child receiving just £50 a month in an investment JISA that earned 5% per year over 18 years would have a pot at the end worth £17,333, from a total contribution of £10,800 – an investment gain of £6,533 without factoring in any charges. 

The same amount put into cash with a 3% interest rate would result in a final pot of just £14,275 – a gain of just £3,475. 

A reason for picking a JISA, is that your child can roll the entire amount accumulated in their JISA into an adult ISA tax-free when they turn 18 – whereas money transferred from a bare trust (more on these below) is restricted to the £20,000 ISA annual allowance.

Start a pension and set your children up for retirement now

While a child might not thank you for this gift now, they will in later life when they realise the true value of starting their pension at a young age.

Non-taxpayers, including children, have an annual gross pension allowance of £3,600 with contributions still attracting 20% tax relief. This means a relative could invest up to £2,880 into a Junior Self-Invested Personal Pension (Junior SIPP) which is then topped by up with £720 from the government.

As with all pensions, returns accumulate free from tax – but of course the recipient would not be able to readily access the pot. Currently the minimum age is 55 but this is set to rise to 57 in April 2028.  

A sum of £2,880 invested every year in a Junior SIPP would mean total contributions of £64,800 over 18 years after the current government tax relief of £12,960 of 20% has been applied.

Were those contributions to grow by an annual compound growth rate of 5%, then at 18 the pension would be worth an impressive £107,619 .

Even if no further contributions were ever made after this age, the pension would be worth an estimated £919,780 by the age of 60 with an annual compound return of 5%!

Giving a child such a huge head start on their pension means they can focus on other financial needs such as raising a house deposit or paying for a wedding.

For really large financial gifts, set up a trust

A trust is a tax-efficient legal arrangement that allows assets of unlimited value to be held by a parent or grandparent as the trustee for the benefit of a child. The simplest trust of all is a bare trust, which allows the trustee to retain control of the assets with contributions able to grow tax-free.

Unlike a Junior SIPP, the money can be accessed any time by the trustee, for example if they want to take out funds to pay for a school trip or private education. But there are some tax considerations too.

The child, for example, is liable for capital gains tax, although there is no tax to pay if the gains realised each year are less than the child’s allowance, which currently stands at £12,300.

Beware, however, that the CGT allowance will halve to £6,000 from April 2023 and halve again to £3,000 from April 2024.

Another consideration is that income from the trust will be taxed against the parent, so these are often more popular with other family members, such as grandparents.

Because trusts can be complicated, those considering a trust with larger amounts of cash or multiple beneficiaries would be wise to consult a financial planner to ensure this is the most tax-efficient strategy for their gift.

For adult children, pick an ISA or Lifetime ISA

In these financially challenging times, some parents and grandparents also want to help out older children too, giving them a lifeline to pay for big financial goals such as a house deposit, a wedding, or clearing student debt.

Adult ISAs can be useful for this, with the gift-giver able to contribute up to £20,000 per tax year, although don’t forget the risks around IHT. Adult ISAs, like JISAs, can be invested either in stocks & shares or cash, with any gains or income free from capital gains tax and income tax – but there are no restrictions on when they can accessed.

For a house deposit, contributing towards a Lifetime ISA is more beneficial, as savers aged between 18 and 39 can contribute up to £4,000 a year into an investment or cash LISA, and the government will top it up by 25%. That’s up to £1,000 of ‘free cash’ a year.

There is one condition, however - the pot must go towards either the purchase of your first property (capped at £450,000 in value) or be held until you are at least 60. Withdrawals before 60, other than for a first property purchase, will be subject to a 25% penalty as the state top-ups are clawed back.

LISAs are great for long-term saving for those between the ages of 18 and 39, however they can continue to pay in and still receive the state top-up until they are 50.

Go traditional and give premium bonds to your loved ones

Premium bonds have been around for almost 70 years with many considering them the safest way to save money because they are 100% backed by HM Treasury. The interest received on the holding is decided by a monthly prize draw with National Savings & Investments increasing the number of Premium Bond prizes it pays out every month from 1 October, effectively boosting increases the prize fund rate from 1.4% to 2.2%.

While this sounds competitive, the rate is less than the top easy-access savings rates available right now plus this is not a guaranteed return as you need to win to gain, with many not receiving any prizes at all over a 12-month period unlike bank interest which is guaranteed.

The good news, however, is parents and relatives can buy up to £50,000 in premium bonds for a child aged under 16, with all the prizes, including the top award of £1 million each month, totally tax-free.

However, unless someone wins big, they will lose value in terms of purchasing power once you factor in inflation. People giving a financial gift like this might also want to consider the implications if a child does win big. If there is more than one child in the family, it might not seem fair if one child suddenly has a huge pot of cash and the others don’t.

Accountancy Daily - Alice Haine(Bestinvest)

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