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Encounters of the third kind

Third-party funding could stop the cry of ’I wish I had started saving sooner’

Steve Meredith: Senior financial planning manager for pensions, Scottish Widows
Steve Meredith: Senior financial planning manager for pensions, Scottish Widows

The end of the tax year will soon be upon us and with it comes the deadline for a host of pension planning opportunities. One of the simpler of these opportunities, but one that is often overlooked, is that of making third-party contributions, which offers consider-able scope for inheritance tax and pen-sion planning. April 5 is the deadline for making a third-party contribution for the 2010/2011 tax year.

Who is involved?
There will normally be three parties involved in the process – the member, the applicant and the donor.

  • The member is the person for whom the pension plan is set up
  • The applicant is normally the member but if the prospective member is under the age of 16 or 18 if not in employment, a contract can only be entered into by the legal guardian. The guardian will be responsible for the contract until the prospective member reaches 18
  • The donor is the person providing the money to be paid into the pension plan

Which of the three parties has to be eligible?
The member has to satisfy the eligibility conditions for the pension plan. However, this is not a requirement for either the legal guardian or the donor. The importance of this point is that parents/grandparents will be able to pay into pension plans for their children/grandchildren, even if the parents/grandparents are no longer resident in the UK.

Who pays the premium?
The process is that the donor makes a gift to the member, who then pays the money into the pension plan. However, as an administration easement the donor will be allowed to make contributions direct into the pension plan on behalf of the member.

Tax treatment of the premiums
The contributions are treated as being paid net of basic rate tax at 20 per cent. The pension provider will claim a basic rate tax credit in respect of the contribution. This means that the donor could pay £2,880 into the pension plan, which would be grossed-up to £3,600 by basic rate tax.
The member will be eligible to claim additional tax relief on the grossed-up £3,600 if, in the unlikely event, he/she is a higher-rate taxpayer. The contributor cannot claim any tax relief for these contributions. £2,880 is treated as being a gift from the donor for IHT purposes (not the grossed-up £3,600).

Third-party contributions are likely to prove a popular IHT planning tool to provide for future generations.

For the donor, four IHT exemptions will generally be appropriate:

1: Small gifts exemption. This allows a gift up to £250 per tax year per recipient to any number of people.
2: Annual exemption. This allows gifts up to £3,000 in total per tax year. If this exemption is not used for any particular tax year, it can be carried forward to the next year. If it is not used in the second year, it is lost.
3: Normal expenditure exemption. This allows for any amount or number of contributions, as long as it can be shown that these contributions are part of normal expenditure, made from income and do not affect the standard of living. It is easier to obtain this exemption if it can be shown that the contributions are of a regular nature, but this does not mean that the contributions must be paid monthly. Annual contributions will still be acceptable.
4. Spouse exemption. This covers gifts between spouses.

Option three is the most flexible and should prove to be the most commonly used but options one and two will suffice for individuals who have limited resources. Pension provision for spouses will be covered under option four.

The main advantages of this approach are that the donor can gift money in his/her lifetime without any possibility of IHT while making pension provision for future generations. The value of the gift is further enhanced by a basic-rate tax credit when it is paid into the pension plan.

The donor does not need to worry about the beneficiaries frittering away the money because the beneficiaries will not have access to the funds until aged at least 55 or earlier if retiring due to ill-health (although the Government is exploring whether allowing early access to pension money would improve the take-up of private pension savings).

The funds will also benefit from the normal treatment of approved pension funds during investment and at the date of taking benefits. The following examples show how substantial fund values can be built up by contributions made by relatives.

Example 1
Nicole has paid £240 a month (grossed up to £300 a month) for her grandson Ian, for 16 years. The fund then remains invested for 44 years until Ian (the member) reaches age 60. After 16 years, the fund value would be over £95,000.

When Ian reaches age 60, the fund value would have grown to nearly £1.2m, assuming a growth rate of 7 per cent a year and an annual management charge of 1 per cent and no other charges.)

If Ian had to provide himself with an equivalent pension fund value without any help, he would have to contribute £720 a month (grossed-up to £900) from age 25 to 60.

Example 2
Tom gifts £240 a month (for 15 years) starting when his daughter Isobel is 30. She is a 40 per cent taxpayer. Isobel can now afford to contribute £400 a month to a pension. After 15 years, her fund is worth over £114,600. At 60, the fund is worth £272,000.
The cost to Tom is £43,200, assuming a growth rate of 7 per cent a year and an annual management charge of 1 per cent and no other charges.

Conclusion
Not many people retire and feel that they have built up enough in their pension pot. A commonly expressed view is “I wish I’d started my pension planning sooner”.

Here is a way to help a loved one start that pension planning and it is possible for that planning to start at birth.

£2,880 (£3,600 gross) is, in many cases, the maximum contribution that can be paid into a pension plan by a third party and this opportunity is often overlooked but as can be seen by these examples this level of contribution can lead to substantial pension fund values and a helpful start may mean that a loved one will never need to say “I wished I’d started my pension saving sooner”.

CASE STUDY
Eligibility is key factor in grand plan to set up pension

Grandad (who is 76 and lives in Australia) is considering leaving his 10-year-old granddaughter (who lives in the UK) either £2,880 in his will or contributing £2,880 to a personal pension on her behalf.

It is not important where the person making the gift is resident or how old they are. What is important is the eligibility of the person for whom the plan is set up. As his granddaughter (who is under 75 and resident in the UK) is eligible, her legal guardian will set up the plan on her behalf. Her legal guardian will be responsible for the contract until she reaches 18.

The £2,880 would be a gift to his grand-daughter and effectively she makes a net contribution to her personal pension. (As an admin-istration easement, her grandad will be allowed to make the contribution direct into the pension plan on behalf of Jenny).

The granddaughter’s net contribution of £2,880 would be grossed up to £3,600.

The tax regime that applies to personal pensions (including stakeholders) means that all personal contributions must be paid net of tax, whether the individual is employed, self-employed or even unemployed.

The granddaughter would only get higher-rate tax relief if she were a higher-rate taxpayer.

There is nothing to stop grandad making a bigger gift but the maximum that his granddaughter can contribute to a regulated pension is 100 per cent of relevant UK earnings or £3,600, whichever is the higher.

Presumably, the 10-year-old granddaughter has no relevant UK earnings so a net contribution of £2,880 a year is the biggest contribution that Jenny can make.

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