The problem: The client is a higher rate earner and faces losing child benefit under the reforms that came into effect this month. Unable to increase pension contributions to offset the changes, are there any other options to offset the impact of the lost income?
The solution: The child benefit tax charge creates a tax trap where it is highly tax efficient to make a pension contribution. Many parents still can not afford to do this and it is an opportunity that they may have to miss due to other financial needs coming first – paying the mortgage, cost of childcare and general daily living costs. But there is a way for parents to keep their child benefit, have more yearly income and which lowers the inheritance tax liability of grandparents.
The Child Benefit Tax charge started on 7 January 2013. In the tax year 2013/14, for every £1,000 of income over £50,000 an individual with three children has, this results in them losing £400 to income tax and £244.90 in child benefit tax charges.
If the affected individual can lower their adjusted net income to below £50,000 by making a pension contribution, then they will retain their child benefit and exit the tax trap.
The benefits of making pension contributions for others are well known: the contribution reduces the donor’s estate for IHT; tax relief is available. The contribution for tax purposes is treated as if made by the recipient so the recipient will get the relief at their marginal rate; the trust and trustees will already be in place; the recipient has no access to the fund until he/she is age 55. Control without the need for a trust; there is no commitment to further payments; the fund enjoys tax advantaged; payments can be varied between recipients; it can be used to relieve the recipient of the need to fund pension in early life when resources are stretched but benefits of pension contributions greatest; it can help the recipient exit a tax trap; and the pension will provide death benefits.
But what about the IHT angle?
Old Mr B has an IHT problem. He needs to decrease his estate. He decides to make a pension contribution for his daughter Mrs C using his annual IHT exemption of £3,000 (the annual income out of expenditure exemption could also be used if the relevant criteria are satisfied). Mrs C has three children, annual net income of £53,750 and a tax charge of £918.38.
Mr B pays £3,000 into Mrs C’s personal pension which means IHT relief for Old Mr B of £1,200 (40 per cent of £3,000).
His daughter, Mrs C then receives the basic rate relief of 20 per cent and the contribution is grossed up to £3,750. Mrs C can then claim higher rate relief of £750 and keep the £918.38 child benefit. This is an effective rate of relief of 64.49 per cent.
Therefore, everyone benefits; Old Mr B as he is lowering his IHT liability and Mrs C who has a pension and more ready cash which she could use to take the three little As on holiday.
The IHT threshold is frozen at £325,000 until April 2014. By using this strategy, the older generation can help their children and grandchildren enjoy the kind of retirement that they currently have, as well as helping them out just now. It also means that advisers can meet another generation of the family.
Or in other words, it is a regular premium IHT mitigation plan with 125 per cent allocation – with some significant fringe benefits for the family.
Clare Moffat is technical manager at Prudential