There are many ways parents can help secure a child’s financial future. Setting up a pension for them is a great place to start.
If you have the spare cash, a little-known tax rule means paying into a child’s pension could give their long-term financial security a triple boost and have additional benefits for you too.
Saving for their future
Under current rules, there is nothing to stop you from contributing to the pension of a child from the moment they are born. But, it is never too late to start.
For example, if your child has recently started work and enrolled into a pension scheme for the first time, the likelihood is they can only make modest contributions. Additional input from you will benefit from compound interest as it grows, helping them to build a more meaningful pot.
As it is money that cannot be touched until later in life, it also acts as an invaluable introduction to the concept of long-term saving for children.
The hidden advantages of a Child’s Pension
Few people are aware of the hidden advantages of paying into the pension pot of their adult children.
A parent who puts money into their child’s pension could be doing them a favour three times over. Here’s why:
- Retirement Pot Boost
A little-known feature of the pensions system is that the contribution made by the parent is treated as if it had been made by the recipient.
So, for example, if you pay £800 into your child’s personal pension, he or she will get the basic rate tax relief on that contribution, taking the amount in the pot up to £1,000.
Perhaps unsurprisingly, there is a limit on how much you can pay into your child’s pension, which is governed by whether or not your child has relevant UK earnings:
- If the child has no earnings or earns less than £3,600 pa, the most a parent can pay into each child’s pension is £2,880 a year (less any pension contributions the child is making themselves). With the basic rate relief that is topped up to £3,600.
- When the child is over 18, they take ownership of the pension. As an adult, if the child is not earning or earns less than £3,600pa, the most a parent can pay in is £2,880 (less any contributions the child is making themselves). Otherwise, the parent’s contribution cannot exceed 100% of the child’s earnings (less any contributions the child is making themselves).
Higher Rate Tax Relief
If your child is a higher rate taxpayer, he or she can claim higher rate tax relief on some or all of the contribution made by you.
This would be done through the annual tax return process, thereby reducing your child’s tax bill.
- Reduced Child Benefit Penalties
If your child is a higher earner receiving child benefit, your contribution could reduce the amount of tax they have to pay.
For example, if your child is earning £60,000 and therefore faces a Child Benefit tax charge of 100%, a pension contribution by you of £8,000, grossed up to £10,000 by tax relief, would reduce your child’s income to £50,000 for this purpose, eliminating the tax charge.
Bonus of a Child’s Pension
Apart from genuinely wanting to secure their children’s financial futures, many parents are interested in the idea of setting up a pension for them for personal reasons.
You may be up against your own annual limits for pension contributions and may therefore have spare cash. Contributions to your child’s pension may reduce future Inheritance Tax bills if they qualify for one of the standard exemptions, such as regular gifts made from surplus income.
The amount that you, as a parent, can contribute with the benefit of pension tax relief is not restricted by your pension tax relief threshold but by the limit that your children face. This will be up to their annual salary or £3,600 if greater. The annual allowance, which is £40,000 pa for most people, can also limit tax-efficient funding for some people – the annual allowance takes into account contributions from all sources (including their employer if applicable) – in some cases unused annual allowance from the last 3 tax years can be added to the current year’s allowance.
Reduced Inheritance Tax
By contributing money into your child’s pension, you could reduce the size of your estate for Inheritance Tax (IHT) purposes after your death, immediately if a valid IHT exemption applies, or after seven years if it doesn’t.
For example, the ‘normal expenditure from income exemption’ – which is unlimited – would apply if your contributions are made from your income and are not at such a level as to reduce your current standard of living and are made on a regular basis, such as an annual contribution from your regular income. Or the £3,000 annual exemption.
Inheritance Tax can be complicated and you would benefit from taking independent professional financial advice to fully understand all of the implications in relation to your individual circumstances.
Supporting each other
Intergenerational financial planning is about how families can use their collective wealth to best support each other during their lifetimes.
If you would like to discuss the options available to you and your loved ones, please get in touch. We look forward to hearing from you.
THE VALUE OF YOUR INVESTMENTS CAN FALL AS WELL AS RISE. YOU MAY GET BACK LESS THAN YOU ORIGINALLY INVESTED.
THE FINANCIAL CONDUCT AUTHORITY DOES NOT REGULATE TAX ADVICE.
INFORMATION IS BASED ON OUR CURRENT UNDERSTANDING OF TAXATION LEGISLATION AND REGULATIONS. ANY LEVELS AND BASES OF, AND RELIEFS FROM, TAXATION ARE SUBJECT TO CHANGE.