I am thinking about setting up a pension fund for my children. What are your views on this?
According to HM Revenue & Customs, about 60,000 minors now have pension plans. Under current pension legislation, parents or grandparents can save up to £3,600 a year gross into a stakeholder pension scheme on behalf of their children or grand-children. You write a cheque for £2,880 and get 20 per cent basic rate tax relief at source. On the face of it, this seems like an interesting tax break and an opportunity to help your children financially at an early age.
Taking this one step further, if the pension contribution is part of an inheritance tax planning strategy, the £2,880 annual contribution falls below the £3,000 annual gift exemption for IHT. This removes the money from the donor’s estate after seven years, potentially saving 40 per cent IHT as well.
Saving income tax, building a nest egg for your children and reducing IHT at the same time almost sounds too good to be true, so what are the disadvantages?
Under current rules, the pension would be inaccessible until the child is 55 and, with increasing longevity, it seems very likely that this will be increased well before your children reach 55. On the positive side, you could argue this gives even more time for the miracle that is compound returns to do their work.
With compound interest, £3,600 a year invested until your child reaches 18 and hen left invested but with no further contributions until 55, earning 7 per cent a year returns after charges, would give your child a pension fund of around £1.7m at age 55. Although this is a huge headline number, remember the fund value would be significantly lower in real terms.
If you are positively rolling in money, have maximised your own pension, fund maximum Isas each year, regularly use your capital gains tax allowance, live in your dream home mortgagefree and have an income that far exceeds your expenditure, then there is not much to lose by putting money away for your children’s retirement.
But not everyone is in that sort of financial position. For those who are not, remember the pension fund will not be accessible for school fees, university costs, help with a deposit on their first home and so on.
This is the big drawback of pensions – the money is locked up and is not always there when you need it. This drawback should not be underestimated.
Also, tax relief is restricted to 20 per cent. If you can get 40 per cent or even 50 per cent tax relief on pension contributions in your own name, wouldn’t it seem a better strategy to maximise this tax relief opportunity and boost your own pension fund with a view to making sure your own finances are such that you can give your children the money when you want to and also when they need it? Or, what about giving the money to your children in their 30s or 40s, perhaps when they themselves might be 40 per cent taxpayers and able to benefit from a higher contribution from HMRC?
Finally, do you want your children to have a pot of money they cannot benefit from until you are in your 80s or 90s or six feet under?
There is still a place for pensions for minors but most articles we see just focus on the tax relief and compound returns without really thinking through some of the drawbacks.
Jason Witcombe is director of Evolve Financial Planning