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Investing in a pension – child’s play?

Published: 16 September 2016

Any adult in a child’s life can get involved in giving them a financial head start. It’s natural to focus on what they might need from age 18. But, by looking to their much longer-term future instead, there may be benefits when it comes to top-ups from the state and inheritance tax.

In the £230,000 reality of raising a child article, we look at the pros and cons of using ISAs to save for a child. These are ideal if you are a grandparent, aunt, uncle or friend who want to help out in the earlier years of a child's life. Another great option for you to consider, however, is a pension.

Why start a pension for a child?

It is probably fair to say that most people don’t think of a pension when it comes to saving for a child’s future. And based on current government proposals, a child born today won't be able to access their pension until they are at least 57. So an ISA is much more likely to spring to mind.

While ISAs mean savings grow free of income or capital gains tax, they don’t currently receive any government contributions. By opening a pension for a child, in contrast, the contributions you make to it attract basic rate tax relief.

Therefore you can save £3,600 gross a year to a child’s pension – the maximum currently allowed assuming the child is not a tax-payer - but a contribution of only £2,880 would be needed as HMRC would top up the payment with £720 in tax relief. There is also the option of spreading this payment across the year with a regular monthly contribution of £240.

By saving £3,600 (but only contributing £2,880) into a Child SIPP every year until age 18, £64,800 could be accumulated (assuming 0% investment growth and no charges taken into account) but crucially only £51,840 will have been paid into the SIPP with the remainder being a benefit to the child of tax relief.

With a Junior ISA the adult would have to save the full £3,600 a year to potentially reach the same £64,800 figure. In both cases though, remember that investments can go down as well as up and you may get back less than you originally invested.

Protecting a child’s inheritance from tax

Another potential worry for adults – particularly parents and grandparents - is that the child’s inheritance will be eroded by tax. So it is worth being aware that there are also inheritance tax advantages to saving in a child’s pension.

Currently an individual can pass on an estate worth up to £325,000 without any inheritance tax applying. If an estate – including assets held in trust and gifts made within seven years of death – it is more than this, inheritance tax will normally be payable at 40% on the amount over the limit.

Many properties in the UK are valued in excess of £325,000 meaning many individuals do need to plan ahead to minimise their beneficiaries’ inheritance tax liability. Making gifts to a child’s pension is one way to do this.

They have the potential to qualify for a number of inheritance tax exemptions, including:

  • One-off 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 child’s pension an ideal way of making use of this exemption.
  • Regular gifts up to the value of £250 made from an individual’s net income can qualify as inheritance tax exempt payments.
If a parent or grandparent gifts any money that is not covered by these exemptions, inheritance tax will only apply if the parent or grandparent dies within 7 years of the gift being made, and it may not be the full 40% inheritance tax rate if several years, though less than 7, have passed.

Balancing the medium and longer term needs of the child

Yes, a child will not be able to take any money out of their pension until they are at least 57. However, the life expectancy of a child born this year in England and Wales is 90 for males and 93 for females.

By setting up a pension for a child, you can help them on the road to a comfortable and hopefully long retirement. And, perhaps more importantly, encourage a saving habit that the child in your life will continue into adulthood.

And it doesn’t have to be an either or decision between a pension and an ISA.

If you are in the fortunate position to be able to put aside £3,600 or more a year for a child but want to balance the benefits of providing for their medium-term future and saving for the longer-term, you could always put money into both.

Cost of raising a child

Important information

These articles are designed to help investors make their own investment decisions. They do not constitute a personal recommendation to invest. If you have any doubts as to their suitability you should seek expert advice. Please be aware that the value of investments can fall as well as rise so you could get back less than you invest.

Your existing pension may have valuable benefits which you might lose when you transfer.

Laws and tax rules may change in the future without notice. The information here is our understanding in August 2016.This information takes no account of your personal circumstances which may have an impact on tax treatment.

Past performance is not a guide to future performance.

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