Wednesday, February 27, 2008

Use your children to save tax

The inadequate increases in income tax personal allowances and tax rate bands in recent years has resulted in more and more people either starting to pay income tax or, even worse, being caught by the higher rate of income tax (because the higher rate threshold is nowadays much closer to average earnings in this country than ever before).

Just to refresh your memory, the higher rate of income tax currently stands at 41% (if you count the national insurance increase).

Today I will tell you how to save tax by legally diverting some of your income to your children.

The taxman tries his best to block diversion of income to minor children to make use of their personal allowances and thus avoid tax. Making direct gifts to children under 18 is not a very wise idea. This is because the income generated by the asset (e.g. interest or dividends on shares), either directly or from a trust set up for their benefit, will be taxed on the parents should it exceed £100 if the money originated with the parents.

Is there a way to ensure that income is taxed on the children so as to efficiently utilize their income tax personal allowances as well as lower-tax bands? Please carry on reading:

Remember that the taxman’s rules about taxation of income apply only to parents. Therefore, to sidestep these rules, get somebody else (e.g. grandparents, assuming they are well-off) to gift money to a trust for the benefit of the children. This way, the income is treated as the children’s and taxed on them. So, in theory up to over £35,000 gross can be diverted to the children without giving rise to the higher rate of income tax.

Diverting capital gains is easier as the rules for capital gains tax are far more relaxing. This means every individual in this country, including children, is entitled to an annual capital gains tax exemption of about £8,000. Any gains below this amount are exempt from CGT. Examples include quoted shares, unit trusts, investment trusts etc.

Use of such legitimate tax planning techniques is suitable to pay the child’s school fees. Although outside the scope of this blog, other tax-free ways to help towards meeting future child costs include Child Trust Funds, ISA’s, stakeholder pension plans etc. These offer different degrees of flexibility, risk and control.

One final word of caution: To keep control of the trust funds so that they are not spent irresponsibly (e.g. if you don’t want your son to spend his trust money on a sports car when he is 18!), you should make sure that you go for the right trust structure since there are different forms of Trusts.
Please contact us if you would like more information.

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