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The cost of a private education in the UK is soaring, with day fees up almost 6pc year-on-year.
On average families can now expect to pay over £5,000 per term for a day school and £13,000 for boarding, according to data from the Independent Schools Council, with the most expensive schools charging in excess of £50,000 a year.
Prices could be about to rise even further, with Labour threatening to remove the VAT exemption on fee-paying schools.
These huge increases have left many middle-class parents unable to cover the cost without the financial support of wealthy grandparents.
But you should think twice before tapping up the bank of grandma and granddad. Depending on who makes the transfer, and when, paying school fees could result in an unexpected inheritance tax bill.
School fees: an inheritance tax break?
No inheritance tax is due on transfers made for the education of children under the age of 18 or in full-time education.
However, there are a few important things to note here. The transfers will only be considered free from inheritance tax if they were made by the parent – except in cases where the child is not in the parent’s care.
In other words, grandparents and other relatives of the child generally will not benefit from the exemption. Even if the transfer is made directly to the school, it will count as a gift and could pose an inheritance tax liability.
This seemingly limits how much help parents can expect to get from other family members. However, there are ways around this.
The annual exemption
Everyone can give away £3,000 a year without paying inheritance tax on the gift.
If you have never used this allowance before, then in the first year you can give away £6,000. This means grandparents could contribute up to £12,000 between them in year one, and then £6,000 for every year after that.
While this will make a dent in the fees, it obviously will not cover the annual cost in full. For those who can contribute more – and want to – there are other options.
The seven-year rule
You can give away sums of unlimited value without paying inheritance tax, as long as you survive the gift by seven years.
Therefore, if possible, it may make sense to pay a larger lump sum towards higher education earlier, rather than cover the fees in instalments every year.
Even then, whether the transfers would be subject to inheritance tax depends on how much of the £325,000 nil-rate band you have by the time you pass away, plus the size of your estate.
Imagine a pair of grandparents have enough saved to cover the school fees of their two grandchildren – which will total £222,000 across their education.
If they had an estate worth £600,000, including their property they were leaving to direct descendants, and had given no other gifts during the timeframe, then they would owe no inheritance tax even if they died within seven years because their assets and gifts would be covered by their combined allowances of £1m.
However, if the grandparents had an estate worth £1m, then the £222,000 would be over their allowances, and dying within seven years would mean inheritance tax was due on the gift.
Alice Haine, of investment platform Bestinvest, said in many cases grandparents who make a substantial gift towards school fees will set up a trust on behalf of the child because of the tax advantages.
“In this situation the trustees retain full control over where the assets are invested and drawn down upon,” she said, “but as the child is the ultimate owner of trust assets, they will be taxed against the child’s income tax and capital gains tax allowances/exemptions, making this very tax efficient.”
The “surplus income” rule
There is another way to give away unlimited sums without having to worry about the seven-year rule.
If you have sufficient surplus income, you can make regular payments to cover the school fees and pay no inheritance tax on the transfers.
However, there are a number of conditions that must be met in order for these payments to be exempt.
Mike Warburton, a former tax director with accountants Grant Thornton, said: “If the payments are regular and out of income so that they do not reduce their standard of living, that would qualify under Section 21 as normal expenditure out of income.”
It is important to keep detailed records of your annual income and outgoings if you are going to use this strategy – after you pass away, HM Revenue and Customs will ask your executor for this information when they come to claim the exemption.