Saving vehicles for children such as the Junior ISA or Child Trust Fund (CTF), are frequently reported as being tax free but it is not always made completely clear which types of tax these vehicles are exempt from and how those taxes would otherwise work. This two-part article looks at the three areas of tax that are relevant to childrens’ savings, Capital Gains Tax (CGT), Inheritance Tax and, in the first part, Income Tax.

Income Tax

As many people will have experienced, Income Tax is a particularly complex area of tax. In its most basic definition it is tax applied to any money which and individual earns as income, but in practice there are a number of distinctions as to which types of income are taxable and which are deemed as exempt.

Bands and Personal Allowance

The level and rate of tax that an individual is required to pay will depend on the overall level of income they receive from all relevant sources. For most, there is a standard Personal Allowance of income, currently standing at £7,475, on which they are not required to pay any tax. More elderly individuals can qualify for higher allowances depending on how much they ‘earn’ whilst there is also an additional Blind Persons Allowance.

Any earnings above these thresholds are subject to tax at rates determined by a series of tax bands. The 20% Basic Rate of tax is currently applied to all earnings above the Personal Allowance and below £37,400, the 40% Higher Rate to earnings between £37,400 and £150,000, and the 50% Additional Rate on any earnings above that level.

Employment Income

The most obvious source of income that is subject to this tax is the money people earn through their employment, whether they are an employee or self employed. However, it is not simply cash in the pay packet that counts - many other benefits in kind such as company cars and medical insurance can also be taxable.

Income tax levied through your work is usually taken through what is known as Pay As You Earn (PAYE) whereby it is deducted from each of your pay packets by your employer and paid directly to the HMRC, unless you are self employed, in which case you are responsible for assessing and paying your own tax.

Investment & Pensions Income

As mentioned previously, Income Tax is applied to any money that people earn and so many other income streams are also affected; the regular income from pensions or annuities is taxable although the you are able to drawn-down 25% of a pension as a tax free lump sum. In addition, income that takes the form of interest accrued on savings is taxable as is investment income such as dividend payments or rental income from property investments (even in some cases from lodgers in your own home).

Interest on savings is (usually) initially taxed at a basic rate of 20% and the monies are deducted from the payment by the bank before it reaches the account although tax refunds or further tax payments may be applicable depending on an individual’s tax band. Tax on dividend payments is also subject to the same tax bands although the rates vary with the Basic Rate standing at 10%, the Higher Rate at 32.5% and the Additional Rate at 42.5%.

There are however, certain types of investment and savings vehicles which have been given special tax free status by the government such as ISAs and Child Trust Funds, where the interest payments and dividends, for example, may be exempted.

Benefits

Perhaps, slightly counter intuitively, even many types of state benefits are subject to Income Tax although the list is generally limited to the benefits which are designed to supplement or replace employment income, such as jobseekers allowance, incapacity benefits (after a certain period of time) and carers allowance. The state benefits which are not subjected to Income Tax are generally those which are awarded to cover particular expenses that an individual encounters in day-to-day living, such as disability related benefits, child benefits and winter fuel allowances for the elderly.

Children Savings

As all income up to the Personal Allowance threshold is exempt from tax anyway, most children’s savings will be unaffected by Income Tax although for those who are fortunate enough to bring in more than the personal allowance there are tax free options available. In particular the Child Trust Funds, Junior ISAs and other NS&I vehicles are free from the usual Income Tax including that on interest payments and dividend tax on investments.

On other non-tax free accounts there is a tax rule in place which is designed to prevent parents exploiting their childrens’ savings accounts in order to avoid Income Tax. Essentially, the income made on contributions/donations made by each parent is only exempt from Income Tax up to the limit of £100. However the limitation does not apply to grandparents or other donors and, as it is applied per person, it can allow for income of up to £400 where there are two step parents (in addition to two parents) involved.

The exemption from the various effects of Income Tax on savings and investments is usually the biggest benefit of a tax free savings vehicle for a child like a Junior ISA, but there are other taxes that need to be considered when planning your child’s financial future. The second part of this article considers the other two relevant areas of Capital Gains and Inheritance Tax.