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A more flexible way of paying for education

Trusts have advantages over endowment policies in saving for school fees, writes Alison Eadie
THE most expensive single commitment parents make towards their offspring is almost certainly paying for their school or university fees.

Current estimates put the average cost of seeing a child through fee- based primary and secondary schools at £100,000. A university student whose parents have a joint residual income of more than £35,000 will receive no government grant. But he or she will still need around £4,000 a year to survive.

Unit and investment trusts, with or without personal equity plan wrappings, are a flexible and tax-efficient way of saving for this expense.

According to the Association of Unit Trusts and Investment Funds (Autif), most school fees schemes are simply "with-profits" endowment policies.

These offer reasonable security, but their fixed-term duration and dependence on an uncertain terminal bonus can make them a less-than-ideal investment.

Penalties for early surrender of endowments are such that in the first few years the investor will get back less than he put in.

By contrast, unit and investment trusts usually benefit from lower front- end charges than insurance-linked products and lower or no surrender penalties.

Autif claims that the stock market should outperform most other types of investment in the longer term and the tax advantages of a PEP provide a benefit that endowments cannot match.

This is because endowments are subject to "fiscal drag", an underlying tax on the life fund of which they are part.

The flexibility of unit and investment trusts also means the money can be used for a different purpose if no longer needed for fees.

Many fund managers have seen the marketing opportunities. Dunedin and Ivory & Sime, both Edinburgh-based investment trust managers, have designed savings packages to utilise children's tax allowances.

Dunedin does it via a trust opened on behalf of a child, usually by parents or grandparents. The person who opens the trust can also be a trustee but must appoint an additional trustee.

The trustees must apply to the Inland Revenue to have dividends paid free of tax. When the child reaches 18, the shares can be transferred into his or her name free of charge.

Dunedin points out that a trust is better than a designated account, as the Inland Revenue can see that the shares are for the child's benefit.

Ivory & Sime's plan, called Prep, can be invested in any of its 10 investment trusts or in two managed portfolios of trusts - high growth and high income. The minimum lump sum accepted is £2,500 or £50 a month in a regular savings plan.

The Prep investor - parent, grandparent or friend - has to sign a declaration that he is acting only as nominee for the child. The investment then benefits from the child's capital gains tax allowance of £5,800 a year rising to £6,000 from 6 April and an annual income tax allowance of £3,445 a year, rising to £3,525.

Tax at 20 per cent deducted at source from dividends can be reclaimed. The drawback for parents acting as nominee is the £100-a-year limit on income per child.

Anything above £100 is taxed at the parent's marginal tax rate. However, I&S points out that provided all income is reinvested, the child's full tax allowance can be utilised.

Zero dividend preference shares are another method favoured by financial advisers as a way of saving for school and university fees.

They are one of the classes of share in a split-capital investment trust, and they rate ahead of income and capital shares on final redemption.

Split capital trusts have a 10-year life. Zeros have a predetermined rate of capital growth and are exempt from income tax because they pay no dividends. They are therefore tax efficient for those who do not use their annual capital gains tax allowance.

However, their redemption value on winding up is not guaranteed. A stock market crash could result in a lower payout than the original investment. But such a risk is negligible, according to Michael Thompson, associate director of stockbrokers Gerrard Vivian Gray.

Mr Thompson believes that zeros have a similar risk profile to gilts. Most zeros are presently yielding between 8 per cent and 10 per cent a year. They are quoted on the stock market and can be bought through a stockbroker.

Parents saving for school fees can invest up to 10 years ahead and put additional money into new split-capital trusts as they open.

The predetermined rate of growth of zeros means the exact amount needed per year for fees, with price rises factored in, can be arrived at by putting in the right initial investment.

When children reach 18 years, the funds can be transferred to them to use up their tax allowances.

Zeros are more suited to lump-sum investors than monthly savers and should not be put into a PEP. While this can be done, as the zeros are not subject to income tax, the PEP manager's fee would be an additional burden on the funds invested.