It’s never too early...

Steve Latto discusses how saving into a pension on behalf of a child can have a major impact on their overall retirement fund

With life expectancy continuing to increase (a newborn today can expect to live to 80), employer financing of pensions on a downward trend and the State Pension Age on the rise, today’s children face a real challenge if they are to have a long and comfortable retirement.

One way that parents, grandparents and others can help is by contributing to a pension for a child.

Contributions to a child’s pension attract tax relief at the basic rate – so, for every £80 contributed, the pension provider will claim an additional £20 and credit this to the child’s pension fund. With tax relief available each tax year on gross contributions of up to £3,600, there is an opportunity to get the government to contribute £720 towards this figure.

The income tax position of the donor of the funds is irrelevant as, for tax purposes, this is treated as a gift to the child which is then paid into their pension fund. Basic rate tax relief is available in all cases.

With early contributions having the ability to compound over a number of decades, the benefits of starting early can be significant.

For example, a monthly gross contribution of £100 (£80 net) made from birth to age 18, assuming growth of 6%, will grow to be in excess of £600,000 by the time the child reaches age 65. Even after taking into account the long-term inflation effect, this will help to provide them with the fund they need for a relaxing and comfortable retirement.

Inheritance tax

However, it is not only the income tax benefits and the long-term growth potential that need to be considered. There is also an inheritance tax planning opportunity, especially for grandparents who are looking to pay contributions into a grandchild’s pension fund.

Gifts made to a child’s pension have the potential to qualify for a number of inheritance tax exemptions:

• Gifts of up to £3,000 each tax year are exempt from inheritance tax – making a gift of £2,880 (the maximum net pension contribution) to a grandchild an ideal way of making use of this exemption.
• Gifts of up to £250 to an individual in a tax year can qualify for the small gifts exemption.
• Regular gifts of payments made out of after-tax income can qualify as inheritance tax exempt payments.

All other payments to the child for investment in their pension will be treated as potentially exempt transfers and will therefore be exempt from inheritance tax if the donor survives for seven years.

In all cases, it is vital that detailed records are kept of gifts made and exemptions used. This will make the job of the executor much simpler and will be useful in case of future challenge from HM Revenue & Customs.

If reliance is made on the gifts out of income exemption details should also be kept of after-tax income in order to prove that the gifts were covered by income without having to draw on capital.

Options

There are a number of options available for those looking to set up a pension for a child – a stakeholder pension, personal pension or, for those looking for wider investment choice, a low cost SIPP.

The pension must be opened by a parent before it passes into the child’s own name at age 18. This allows the parent to monitor contributions, especially if these are financed by a number of family members, to ensure that the annual tax-relievable contribution limit is not exceeded.

The normal rules remain after the pension is passed into the child’s name – they will not be able to access the fund until age 55 (assuming no further change to the benefit rules). At least this prevents them blowing the fund on a motorbike and allows them to focus on other, more immediate, priorities such as financing their education or a deposit for their first home.

With the latest HMRC statistics revealing that, since pensions for children became available in 2001, only around 20,000 children in the UK have someone saving into a pension for them. This is surely a market that will continue to grow as parents and grandparents look to take advantage of the tax advantages on offer.

Steve Latto is pensions development manager at Alliance Trust