Pass on good habits as well as your wealth

As well as helping out younger members of your family there could also be inheritance tax (IHT) benefits to giving away assets during your lifetime. This is particularly the case if the value of your estate is worth more than the £325,000 nil-rate band threshold at the time of your death, as the value of your estate above that, other than your family home, could incur IHT at 40 per cent.

Some wealth managers even advocate skipping a generation, suggesting grandparents pass on assets to their grandchildren, rather than their middle-aged children who are more likely to have property and benefit from more generous pensions.

"Families need to plan to bequeath a large chunk of their estate to their younger generations, giving less or even nothing to their immediate children, to allow the capital to enjoy the long-term benefits of compounding, which Einstein called the eighth wonder of the world," says Paul Killik, partner at Killik & Co. "We still live by the mores of the nineteenth century, with the expectation that parents should bequeath to their immediate children. In so doing inheritance tax will have taken three bites out of the original capital before it gets to the fourth generation [which is becoming more common], and it continues to remain in the hands of the oldest generation throughout, giving little chance for long-term growth."

Living inheritances can also be a good way of transferring money management knowledge to younger generations. "Sometimes when [adult] children are not used to managing wealth and suddenly come into a large inheritance they don't know how to handle it," says Julia Rosenbloom, partner at Smith & Williamson. "It can be useful to have the parents on hand, passing assets down through their lifetime, so they go through that education process as it can be difficult for people with no real experience of what it means to manage a large sum of money. If children go and spend it on Ferraris and substantial holidays, the family wealth can be quickly eroded."

But there are also risks with living inheritances. Once you have given money or assets away you can no longer benefit from them. And if you end up living a long time or need to pay for long-term care you may find yourself in difficulty in later life.

"Giving away assets during your lifetime is a simple way to reduce the size of your estate for inheritance tax purposes," says Patrick Connolly, certified financial planner at Chase de Vere. "But the bottom line is that you shouldn't give away any money or assets that you might need to rely on in the future."

So if you are considering a living inheritance, Danny Cox, chartered financial planner at Hargreaves Lansdown, suggests retaining a large contingency fund for yourself that you can draw on if necessary.

Giving away income or assets

There are various ways to pass wealth to younger generations while you are still alive. You can pass on your wealth by giving away assets, including cash and shares, as tax-free gifts. This is known as a potentially exempt transfer (PET) and has to be an outright gift from which you can no longer benefit. You need to survive for seven years after making the gift for it to be fully IHT-free, although the tax payable is reduced on a tapering basis from the third year after you made the gift. 

Source: www.gov.uk

However PETs cannot be used to give away your family home if you continue to live there unless you pay rent at a market rate to your heir. "If you want to give money during your lifetime the most common way to do this is as a lump sum through PET," says Charles Calkin, financial planner at James Hambro & Co. "This is a clean way to gift substantial sums, but can encourage people to give away too much too soon."

So instead you could give assets away more gradually out of your surplus income. The advantage of giving away some of your income is that you don't need to dip into your capital. And as long as the money you are giving away still leaves you with enough income to maintain your usual standard of living, the gift is IHT-free. 

Petronella West, director, private clients at Investment Quorum, explains: "If, for example, you're earning £100,000 and can show that your expenses only add up to £80,000 and you're gifting away £10,000, then you can prove that you've got more than sufficient income to meet your own income needs."

For those with larger incomes the ability to gift money this way can be a very tax-efficient method of reducing potential IHT liability while passing wealth to children or grandchildren. But the IHT exemptions for gifting surplus income are not given automatically and will need to be claimed from HM Revenue & Customs by your executors after your death. So make sure you keep detailed records.

You can also gift income using your annual gift allowance, which every year allows you to give away assets or cash worth up to £3,000 IHT-free. This rises to £6,000 if you did not make a gift of this kind in the previous tax year. A married couple giving for the first time could therefore hand over £12,000 to their children in one year. After that, the maximum you can give IHT-free reverts to £3,000 per person per year .

A parent can also give up to £5,000 to each of their children for a wedding without incurring tax, a grandparent can give up to £2,500 and everyone else can give up to £1,000.

Using a discretionary trust

Assets held within a trust are not counted within an individual's estate for IHT purposes. And discretionary trusts also allow you to control how the funds within them are accessed, even by adult children. Most parents and grandparents gifting assets to younger family members want to maintain some control.

Depending on the trust deed, trustees of a discretionary trust can decide:

• What gets paid out (income or capital).

• Which beneficiary to make payments to.

• How often payments are made.

• The conditions imposed on the beneficiaries.

Ms Rosenbloom says: "I've got one client trust of which the beneficiaries are in their late 30s. The father set up the trust when the children were very small. He's long since passed away, but by transferring money into that trust before he died, the value of the trust was not in his estate for IHT purposes so saved his beneficiaries some tax. Meanwhile the trustees have been content to distribute income to the children in question but not the capital, as one of the children had some marital difficulties and the trustees were concerned the funds would [end up in the wrong hands.]"

Discretionary trusts can also be useful for planning for the future needs of your children or grandchildren, including those not yet born. For example, you can describe the beneficiaries simply as 'the grandchildren', and as your family grows all the grandchildren can be included and treated equally.

But despite some IHT benefits, trusts are quite heavily taxed. Any transfer into a trust above the £325,000 nil-rate band will incur an immediate IHT charge of 20 per cent. And a further 20 per cent may be charged if the person funding the trust dies within seven years.

Any gross income above £1,000 the trust receives is taxed at the trust tax rate of 45 per cent, except for dividends which are taxable at 38.1 per cent. However, if the trustees distribute income to beneficiaries who pay income tax at less than 45 per cent, then the beneficiary can reclaim that tax.

Trusts are also taxed every 10 years on the value of the assets within them above the nil-rate band at a rate of up to 6 per cent. And an exit charge of up to 6 per cent may apply if capital is distributed in between the 10-year charge.

"A discretionary trust isn't terribly tax-efficient," says Kay Ingram, director of public policy at financial planning firm LEBC. "In my experience, most people use discretionary trusts when they don't know what the future holds or they want more control of the assets in the trust. The IHT tax benefits are not the main thing."

Setting up a family investment company

If you have substantial assets, you could consider family investment companies (FIC), rather than a trust, to pass on assets to children and grandchildren. These allow you to pass on assets without giving up control of them.

A family investment company can be set up and managed in the form of a single private company. Typically, it will be run by the parents or grandparents as company directors, with family members such as children and grandchildren owning the shares.

"At heart a family investment company has two share classes, one that has voting control and one that has economic rights, such as receipt of dividends or the capital on liquidation," explains Ms Rosenbloom.

Investment decisions are made by the directors, with the company often able to hold various types of assets including rental properties, shares and investment funds.

"Companies have got quite a nice tax regime, which is in many ways more favourable from an income and capital gains tax perspective than that for individuals and trusts," says Ms Rosenbloom. "A discretionary trust will pay income tax at the highest income rate, but a company will pay income at the corporate tax rate of 19 per cent, while most dividends received by companies are tax-free."

Although relatively straightforward to establish, FICs have set-up and running costs, and need to prepare annual accounts and corporation tax returns. You are also likely to need help from a professional wealth manager to set one up.

Passing down the wealth mindset

As well as passing on wealth to younger generations in the most tax-efficient way, many people would like their children and grandchildren to develop good saving and investment habits, as they would be more likely to use the family wealth wisely and even build on it.

"What I've discovered over the years working with many families (and I see it with my own children too) is that even though you've brought up children in the same environment, they can have very different attitudes to money," says Ms Ingram. "Maybe one child is a big saver - even a bit of a scrooge - and a bit too cautious with money, while another child will be much more free and easy, and potentially even reckless. Just because parents have good savings habits doesn't mean that the kids will display the same good habits."

But you can help encourage younger members of your family to save, invest and acquire good financial habits. "It's down to the parents in conjunction with their financial planner to educate children on financial matters as you're not born with an innate understanding of how to invest," says Ms Rosenbloom.

Ms West thinks it is a good idea to have a family charter. "You and your kids sit down without any in-laws or external family present, and discuss what the money you are passing down to them is for, she explains. "Parents can impart some of their values surrounding the money, for example by making it clear they've worked really hard for it, so it's about the kids protecting the legacy and not an entitlement to spend it. And  it's good to involve children – even younger ones – in the long-term financial planning as children are perfectly capable of understanding financial decisions."

You could also offer incentives, encouraging children to save money by adding additional amounts depending on how much they save, so that they can see a real benefit in saving their money. "The current interest rates offered by banks and building societies aren't particularly exciting, but perhaps if parents match how much the children manage to save for themselves this will encourage a savings mentality," says Mr Connolly.

Mr Cox adds: "Once my kids are of an age to want to get on the property ladder I aim to match whatever they've saved. The typical deposit you need now is £33,000, which is a huge amount to save, especially when you've got the rest of life to deal with. But you also want to get the right balance between encouraging your children or grandchildren to bear some of that pain themselves by not making it too easy for them."

Case studies

Experimenting with small sums

"A grandfather had some investment bonds that were surplus to his own needs," says Ms Ingram. "He had 12 grandchildren and when they each reached 18 he assigned 1/12th of the investment to each of them. This was highly tax-efficient as he was a top-rate taxpayer, but they were nil or basic rate payers, so could encash the funds with a lower tax bill applying. He explained this simple fact to them, but then left each grandchild to decide how to use the money. He wanted them to learn about investing and saving, and felt this was the best way. If they lost money it would be a useful lesson with a relatively modest amount, and would give them the incentive to find out more about savings and investments."

Ms West adds: "I worked with a family with three children aged 13, 15 and 17. The parents gave them £1,000 each to invest for a charity of their choice. The kids each opened a general investment account on the platform their parents use, which was helpful as the parents could see all of the family accounts in one place."   

Buying advice

Ms Ingram says: "A mother received an inheritance from her mother and wanted to pass on the funds to her daughter, a trainee lawyer with high graduate debt. Initially she asked us to recommend an individual savings account (Isa) investment for her daughter. We suggested that instead of making the investment decision for her daughter, it would be a good opportunity for her daughter to receive advice on her options, which could include paying off her student loan, taking advantage of the new Lifetime Isa for a future house purchase and establishing an emergency fund."

Setting a test

"A client recently told me he was going to offer his two graduate daughters a gift of £2,000 each, but he would only give it on condition that they produced a report for him, having researched the investment options," says Ms Ingram.

Another father of four grown-up children received a windfall from his share options. He gave each child a generous lump sum hoping they would use it to reduce mortgages or to save. But only one of the four used it sensibly in his view. "So he changed his will so that they will inherit his estate via a trust, with the trustees given discretionary powers to distribute the capital and income," explains Ms Ingram. "In this way parents can maintain control over assets after death, which can also be beneficial if an intended heir gets into financial difficulty, for example because of divorce, business failure or addiction."