Succession planning has always been a “hot topic” for individuals who would like to preserve, grow, and transfer family wealth to the next generation. For parents and indeed grandparents, this goal is likely to be high on the agenda, as it not only builds a robust framework for passing on wealth efficiently, but also provides a child or grandchild with a great head start in life.
The initial go-to options when saving money for a child or grandchild’s future, are typically standard saving accounts and Junior Individual Savings Accounts (JISAs). A great first step, but what else may be considered if the return on a run of the mill savings account is uninspiring, or if the annual allowance of £9,000 for the 2023/2024 tax year for a JISA has been exhausted?
An individual pension is often overlooked as an alternative option that could provide significant value and offer substantial benefits whilst serving as a powerful tool for wealth transfer. Let’s delve into why starting a pension for a child or grandchild is advantageous, along with the specific benefits it provides.
Of course, as with any financial decision, there are some drawbacks which we will consider, too.
1. Contributions that attract tax relief
Similarly, to adult pensions, a junior pension, or a self-invested personal pension (SIPP) for children also qualifies for tax relief.
For most children who do not have their own earnings, the total gross amount, including tax relief, that can be contributed to a junior pension is £3,600 in the 2023/24 tax year. In simple terms, this means a contribution of £2,880 from a parent or grandparent into a junior pension would receive a top-up, or “tax relief” of £720 from the Government.
If the child has earnings above £3,600, then the limits for tax-efficient contributions mirror that of an adult pension. In the 2023/24 tax year, this is either £60,000 or 100% of their earnings, whichever is lower.
The benefit of tax relief sets pensions apart from savings accounts and JISAs, as they do not provide such benefits. Additionally, this extra boost means that returns on your contributions will compound even more effectively, amplifying the growth potential of the pension fund – a win, win!
2. More time in the market could lead to greater investment returns
Starting a pension for a child takes the adage of “time in the market rather than timing the market” to the next level, as funds will remain within the pension until the child or grandchild reaches retirement age. This longer time frame can be highly valuable in providing a sizable pot for the child or grandchild’s future.
The example below from Unbiased highlights the impact of regular government top-ups, plus the effect of compounding interest over the longer-term on funds held within a junior pension.
Figures suggest that if contributions are maximised to £3,600 gross each year from the moment a child or grandchild is born until they turn 18 then, assuming no further contributions and growth of 4% (net of charges) a year, the pension could be worth in excess of £620,000 by the time the child or grandchild turns 65.
Furthermore, the child or grandchild has the option of commencing personal contributions to the pension when they begin working. This could help build an even larger pot during their working lives – and they will continue to benefit even further from greater compound returns.
The returns accumulated within the pot will be entirely free from Capital Gains Tax (CGT) too, making a pension an extremely tax-efficient avenue for long-term investment.
3. Contributing to their financial future
Perhaps the most significant benefit of starting a pension for a child or grandchild is that it is an effective way of enhancing their financial future.
The key factor contributing to this benefit is the restricted access to the pension funds until at least the normal minimum pension age, which is currently set at 55 (as of 2023/24) and is scheduled to increase to 57 by 2028. There is even a possibility of further increases over the next several decades of the child’s life.
By limiting access to the funds until later in life, the pension safeguards against the possibility of impulsive spending during the child or grandchild’s younger years, thereby preserving the money set aside for their benefit.
Furthermore, this approach grants them greater financial freedom throughout their working life. Knowing that there is a dedicated retirement fund waiting for them in later years can alleviate concerns about economic uncertainties, providing them with a sense of security and peace of mind.
They can rest assured that funds are saved specifically for their future needs, thanks to thoughtful financial planning during their early years.
4. It can have Inheritance Tax benefits for you
Another advantage of regularly contributing to a child or grandchild’s pension is the potential eligibility for utilising the “gifting from income” exemption in relation to Inheritance Tax (IHT).
Under this exemption, unlimited regular payments or “gifts” can be made into the junior pension and will generally fall outside the estate for IHT purposes. To qualify for this exemption, there are a few conditions to consider:
Affordability: Ensure the payments towards the child or grandchild’s pension will not adversely impact your standard of living.
Source of Payments: The contributions should be made from regular monthly income, not from capital assets.
Regularity: It is important that the payments are made on a consistent and regular basis.
If you plan to employ this strategy, it is beneficial to maintain clear and detailed records of all the gifts made as part of the financial planning process.
Considerations of starting a junior pension
1. Limitation of tax allowable contributions
Although the tax relief offered by a pension is attractive, it is important to acknowledge that there are limits to how much can be saved for a child or grandchild.
High net worth individuals may have significant sums to transfer to a child or grandchild. As annual contributions will be limited to £2,880 (net) whilst still receiving tax relief, this may appear to be a mere drop in the ocean of the total wealth anticipating being passed on.
In this scenario, it would be worth exploring various avenues and consolidating the options into a seamless strategy whereby establishing a robust succession of wealth.
It is important to recognise that a pension serves as a valuable tool for providing financial support to the child or grandchild’s future rather than immediately.
While the minimum pension age prevents them from squandering the funds during their youth, it may also restrict their ability to achieve legitimate financial goals that they may have.
As a result, a pension may not be suitable if there are other, shorter-term goals within the financial plan. For example, common ways that many parents and grandparents like to support children or grandchildren are:
• Helping with a first car purchase
• Paying tuition fees or living costs at university
• Gifting a deposit for buying a first home.
Saving accounts or JISAs are often utilised to fulfil such immediate goals and can offer more flexibility in accessing funds compared to a pension.
3. Investment returns are not guaranteed
Lastly, an important aspect to bear in mind is that investment returns are never guaranteed.
An equity-based portfolio is likely to deliver positive, above inflation returns over the longer-term as has been the case of over 200 years of investment history. Of course, over the short-term, volatility will be a key emotive driver as returns are not delivered in straight lines of steadily accumulating returns.
Growth can be lumpy and often delivered in spurts over short periods, but it is impossible to predict when these might happen. Circulating back to the aforementioned old adage of “time in the market rather than timing the market” and as junior pension funds could be invested for half a century or more, the likelihood of a positive outcome is reasonably high.
However, if the thought of an investment losing money over the short-term is unsettling, then a regular savings account may be the best option for you.
A financial planner can help create a suitable plan for your family’s future
When it comes to making decisions about succession planning, the pressure can often feel greater than when making decisions for yourself.
This is because the choices made may have the potential to significantly impact the financial well-being of the family in the future.
If you would like to begin the conversation around succession planning, we strongly encourage you to reach out to your financial planner for further guidance and information.
The Financial Conduct Authority does not regulate estate planning, tax planning or will writing.
A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future results.
The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates and tax legislation may change in subsequent Finance Acts.