FOOL SCHOOL
How Children Are Taxed

February 11, 2005

It is worth trying to keep tax on children's savings to a minimum, but it is important never to let the tax tail wag the investment dog, as the saying goes.

How a child's savings income is treated for tax purposes will depend partly on who gave them the money: parents, grandparents, relatives or other adults.

Money from parents

If the income from these savings is not more than £100 per tax year, it is treated as the child's income and is normally free of tax. If it is more than £100, it is treated as the parent's income and is subject to their highest rate of tax. This rule applies to each parent individually, so if gifts are made separately by each parent, the child could receive up to £200 of income before tax is levied.

Once the child reaches 18, all income is treated as the child's own. (One exception to the £100 rule is the interest on the National Savings Children's Bonus Bond which is treated as the child's regardless of who provided the money to buy the bonds.)

Money from grandparents

Money from grandparents, relatives or other adults - any income arising from this money is treated as the child's own. Like adults, children have their own personal tax allowance, which is £4,745 for the 2004/05 tax year, so any income they receive within that limit on this money will be free of tax. These rules apply to all types of income.

In the case of bank and building society accounts, you can prevent any tax being deducted from the interest on your children's savings by completing Inland Revenue form IR85, which will register your child as a non-taxpayer. Your branch should be able to provide this form. This registration will be valid until the child reaches age 16, when they will have to re-register personally. If tax has been deducted it can be reclaimed up to six years later. You will need to contact your tax office for details.

Share dividends (which include income paid by most investment trusts and unit trusts) are paid to investors net of a 'tax credit', currently 10%. Basic and lower rate taxpayers have no further tax to pay. But even though children are normally non-taxpayers, they cannot reclaim this tax.

Capital Gains Tax

Like adults, children also have their own annual capital gains tax allowance which is £8,200 for the 2004/05 tax year. This allowance applies whatever the source of the original capital, so if parents want to give substantial amounts to their children, the most tax-efficient investments will be those which are likely to produce capital growth. Even if the eventual gains exceed the annual tax-free allowance, it may still be possible to minimise tax by phasing withdrawals over more than one tax year.

Inheritance Tax

Rising property prices are pushing increasing numbers of home-owners into the inheritance tax bracket, which starts when your assets exceed £263,000 for the 2004/05 tax year. Any wealth you own above this amount, including the proceeds from selling your house, will be taxed at 40% on death, with the main exception being gifts made to your spouse. Fortunately, there are ways of reducing your potential liability. One of the most effective, if you can afford it, is to make gifts during your lifetime.

Although inheritance tax may become payable on gifts made during your lifetime (this would be at a rate of 20%), in practice most gifts will be free of tax, because you can take advantage of various exemptions that are available. These are divided into two categories immediately exempt transfers and potentially exempt transfers.

The main ones to note are:

• Annual gifts of up to £3,000. Individuals have a £3,000 limit. This amount can be given to one recipient or divided among several. If the allowance is not used in one year, it can be carried forward to the next year only.
• Any number of gifts of up to £250 per recipient per year. It is important that a recipient does not receive any more than this amount or the exemption will be lost. You cannot for example, give both a £3,000 gift and a £250 gift to the same person.
• Gifts of any amount which are funded out of your normal spending, provided they don't reduce your normal standard of living.
• Gifts for the maintenance of your family, such as for children under 18 or still in full-time education. There is no specific limit on these gifts.
• Gifts made on marriage. Parents can give up to £5,000 to a child (each parent has the same allowance); grandparents can give up to £2,500 each and for any other adult the limit is £1,000.

Potentially exempt transfers

Any gifts exceeding the immediately exempt transfer limits would be counted as potentially exempt transfers. This means that if you live for seven years after the gift is made, they will not be liable to inheritance tax (IHT). If you die earlier, they will be counted against your tax-free allowance (i.e. the first £263,000 in 2004/05). If they exceed that amount, the tax payable will depend on how long you have lived since making the gift - as shown in the table below. Years between % of full IHT rate gift and death (40%) payable:

0-3: 100%
3-4: 80%
4-5: 60%
5-6: 40%
6-7: 20%
7+ : Nil

For example, if you die within three years of making the gift, the full amount of any inheritance tax on the gift will be payable. If you die between three and four years later, only 80% of that amount will be due.

Passing money to children on death

If you have children, it is vital to make a will. This can help save tax on your assets. Couples can use their wills to ensure they utilise the tax-free allowance for inheritance tax twice over. Instead of leaving all their assets to each other on death, each can create a discretionary trust in their will for an amount up to the starting limit for tax (£263,000 in 2004/05) for a range of beneficiaries including their surviving spouse, children and grandchildren. This money will not form part of the surviving spouse's assets, even though they may continue to derive a benefit, such as an income, from those assets at the trustees' discretion. On the death of the surviving spouse, a further tax-free allowance will apply to that spouse's assets.

Please note that all the above is provided for information purposes only.

Find out more in our Saving For Children centre.