Archived article
Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.
If you have diligently saved for your children, you would not expect to be hit with a tax bill yourself, but a little-known tax rule could mean just that.
The ‘parental settlement rule’ means that once a child earns £100 or more in interest on their savings account on money that has been gifted by parents, it is taxed as though it is the parent’s money. This rule was introduced in 1999, and the £100 income limit has been in place at that level ever since.
When interest rates were at historic lows, it was not much of a concern. But the top children’s easy-access account pays 5.20%*, which means that once you have more than £1,920 saved, you will hit that £100 limit.
If you reach £100 then all that interest (not just the interest over £100) is counted as though it’s the parents’ and will count towards their Personal Savings Allowance (PSA).
The PSA means that basic-rate taxpayers can earn £1,000 in savings income before they pay tax on it, while higher-rate taxpayers have a £500 allowance. Additional-rate taxpayers have no allowance.
If your savings interest plus your child’s is still within your PSA then you will have no tax to pay. But if you have already used up the allowance (or your child’s savings tips you over) then you will have to pay tax on that money, at your income tax rate.
Tax hit on your child's savings
| Child's savings pot | Tax cost - basic rate | Tax cost - higher rate |
|---|---|---|
| £3,000 | £30 | £60 |
| £5,000 | £50 | £100 |
| £10,000 | £100 | £200 |
| £20,000 | £200 | £400 |
Source: AJ Bell. Figures assume interest rate of 5% on child's savings, that the money has been entirely contributed by parents and that the parent has already breached their Personal Savings Allowance.
The limit is intended to stop parents funneling their savings into accounts under their child’s name to avoid tax – but the £100 limit is out of date and should be increased, to at least £500. This would prevent parents being caught out and having to report to HMRC for small sums but would still act as a barrier to aggressive tax avoidance.
For now, here are three ways to avoid being hit with the tax rule by organising your savings, using alternative accounts or drafting in grandparents.
1. Use an ISA
The main option is using ISAs, as interest earned on ISA accounts isn’t taxable. You can pay up to £9,000 per child into an ISA each tax year, which means anyone who has built up decent savings outside an ISA can transfer up to that amount each year. But that money cannot be accessed until the child turns 18, when it matures into an ISA in their own name. The top easy-access cash Junior ISA account pays 5.2% – the same as a non-ISA account. However, as ISA rates are often lower, so you would have to work out, based on how much you have saved and your income tax rate, whether you are better opting for the higher paying account and paying tax on the interest, or the lower paying account with no tax hit.
Alternatively, you could consider investing. Lots of money saved for children sits in cash accounts, but really if you are saving for 10, 15 or even 18 years that is the ideal time horizon for investing.
Investing could ensure your child’s savings beat inflation over the long term. You can open a Junior ISA in their name, which will become theirs when they turn 18, or you can choose to invest the money in your own ISA, if you have some of your annual limit left.
2. Gift from both parents
The limit is £100 per parent, per child. Think carefully about how you give any money to your children. If you are gifting from individual accounts, you should ensure you are making equal payments to their children, rather than one of you making all the transfers to the child’s savings account – to save you hitting the tax limit far quicker. If you have a joint account, the money will be assumed as coming 50:50 from each of you.
If one of you has any Personal Savings Allowance remaining, you could consider being the one to give your child/children money, as any interest will be added to your own.
If the combined sums are still within your tax-free savings allowance, they will not have to pay any tax on the money.
If you know you are going to hit the £100 limit, even with spreading the money between you both, you should ensure the money comes from the lower taxpayer.
If one of you is a basic-rate taxpayer while the other is a higher-rate payer, you should gift the money from the basic-rate payer, as you will benefit from a higher PSA and you will pay 20% tax on the savings interest rather than 40%.
3. Get family and friends involved
A third way around this annoying tax rule is getting friends or family to contribute to the accounts instead. The £100 limit only applies to money given to the child by parents; any money paid into the accounts by grandparents, other family or friends does not count towards the limit, so if grandparents fund the accounts or friends pay birthday money in then you will not hit the tax limit.
You should keep hold of any evidence that payments have been made by other people, so you can show it to HMRC if you need to.
*According to Moneyfacts, accurate to 15 August