Building on our recent comments about Child Trust Funds, there is another way that grandparents (in particular) can help the next generation and do some effective inheritance tax planning at the same time.

I know it will sound rather strange talking about making pension contributions for children, particularly since they will not be able to access the money until they are 55 – and that is provided the minimum age is not hiked again in future, as it is due to be (from 50 to 55) in April.

There are, however, a number of reasons why this could be a good idea and an ideal complement to Child Trust Funds (CTFs).

Higher contribution limits
CTFs are limited to an annual contribution of £1,200 per child. Pensions, on the other hand are limited to £3,600 a year for non-earners and, importantly, you only have to pay £2,880 of this as the balance is made up by the taxman in the form of basic rate tax relief. Of course, if the basic rate of tax changes, so will the net payment so a rise back to 22p, or higher, might not be so bad in some cases.

Like Child Trust Funds, pensions grow free of tax. This means that there is no income or capital gains tax on money within the fund, although dividends from UK companies are taxed at source (at 10%) and this cannot be recovered.

Access to money much later
Unlike CTFs, which are available to the child as a lump sum at age 18, pension funds are not currently available until age 55 (although some pension commentators favour a move to the US 401K system of pensions, which allows limited access to funds earlier on).

There are restrictions about how the money is taken. Only 25% can currently be taken as tax free cash, the balance must be taken as an income, either directly from the fund, or through the purchase of an annuity (there are also likely to be new ways of taking an income by the time our children come to retire). Under the current rules, it is possible to take the lump sum and defer drawing an income as late as age 75, if required.

Delaying the age at which children get access to their money is a good way of ensuring that it is not all blown on a motorcycle. On the other hand maybe 55 will be the new 18, by then! 

Inheritance tax implications
Another reason for considering providing a pension for children and grandchildren is that there are potential tax planning advantages. The contribution of £3,600 is actually higher than the annual allowance for gifts that are free of inheritance tax. However, larger gifts are allowed provided they come from normal income expenditure (which basically means that making them does not reduce the donor’s standard of living) and if the donor lives at least seven years after each gift (or potentially exempt transfer) then no inheritance tax can apply.

This means that the money given is outside the donor’s estate on death; and pension schemes are not subject to the sort of tax that applies to other forms of trust.

It is important to take professional advice before making any decision relating to your personal finances. As ever the value of investments is not guaranteed and will fluctuate; you may get back less than you put in.

NOTHING CONTAINED IN THE ARTICLE SHOULD BE CONSIDERED AS GIVING INDIVIDUAL FINANCIAL ADVICE. THE VALUE OF INVESTMENTS IS NOT GUARANTEED AND WILL FLUCTUATE. YOU MAY GET BACK LESS THAN YOU INVEST. PLEASE NOTE THAT THERE MAY BE VARIATIONS FOR THOSE LIVING IN SCOTLAND AND NORTHERN IRELAND.