3rd party contributions - Saving for future generations
We look at how your clients can start saving for their children and grandchildren’s retirement.
Providing a decent pension to live on is an expensive business. To provide an income of £35,600 a year from age 65 would require retirement savings of around £600,0001.
It’s possible for someone else to make a pension contribution on your behalf. So one way doting parents or grandparents can ease the burden for their children and grandchildren is to kick start their retirement savings for them.
1 MoneyHelper: paid monthly in arrears, single life, no annual increases and no guarantee period.
HMRC treat the contributions as if they had been made by the child. So assuming the child has no earnings, the maximum gross tax relievable contributions that can be made are £3,600 each tax year. If they do have earnings, the maximum gross tax relievable contribution is 100% of those earnings.
Let’s say Lucy wants to make a pension contribution for her 4-year-old grandson Mark. The plan would be set up by Mark’s legal guardian (usually one of his parents) with the contributions made by Lucy.
She could contribute up to £3,600 a year gross into the plan. But if Mark had earnings (say he appeared in children’s clothing commercials) then up to 100% of those earnings could be paid.
If he was a higher rate taxpayer, Mark could claim higher rate tax relief based on his tax situation, not Lucy.
The contributions are classed as gifts for IHT purposes but the usual exemptions apply. £3,000 can be paid as an exempt gift and this more than covers the £2,880 net contribution payable if Mark has no earnings. However, if Lucy can show regular contributions can be paid out of her income without affecting her standard of living, they would be exempt without the need to use the £3,000 exemption.
If none of the exemptions apply but Lucy survives for at least 7 years after making a contribution, that contribution would be IHT free via the potentially exempt transfer route.
In our previous case study we looked at how third party contributions can help individuals kick start future generation's retirement savings. In this case study we look at how this works in practice and the benefits it can offer:
- Martin, age 63, is a retired senior manager with a renewable energy company.
- He is widowed with one daughter, Maria, who is 35.
- Martin receives a yearly retirement income from his defined benefit scheme of £60,000 but he only needs £35,000 a year to meet his living costs.
- Martin has assets in excess of £1.2 million and is worried about the amount his daughter will pay in inheritance tax when he dies.
Maria has one son, Hamish who is 4. Martin wants to provide financially for his grandchild’s future but does not want him to have access to the money at a young age. He has already rejected the idea of putting a large amount of money into trust.
Providing for the future
Martin sets up a pension plan for Hamish, and contributes £2,880 each year. Once tax relief has been added, his contribution is increased to £3,600.
If Martin saves this amount every year until Hamish’s turns 18, there will be around £81,567 in Hamish's pension. This assumes investment growth of 5% excluding charges.
If no further contributions are made, when Hamish reaches age 60 he could have retirement savings of £633,089, assuming investments continue to grow at 5% excluding charges.
Martin could carry on making contributions after Hamish reaches 18 or he might think about saving into another vehicle, such as a lifetime ISA, to help with a house purchase.
Martin could use his annual exemption or the ‘normal expenditure from income’ exemption. The annual IHT saving would be 40% x £2,880 (pension contribution) = £1,152.
Is Martin missing a generation?
Saving for grandchildren is a great idea but Martin can also help his daughter Maria. She has an adjusted net income of £55,000. This means she is caught in the child benefit tax trap. For the £5,000 of income she has over the £50,000 threshold, she currently only receives £2,430 (£5,000 gross income, minus £1,946 income tax, minus £624 child benefit tax charge).
Maria knows that making a pension contribution can take her out of the trap but she doesn’t have enough disposable income to do that.
However, if Martin makes a pension contribution to Maria’s plan of £4,000 a year, basic rate tax relief increases the contribution to £5,000. This is deducted from Maria’s adjusted net income and she is no longer in the trap.
This gross contribution of £5,000 brings her adjusted net income for child benefit purposes down to £50,000, which means she avoids the child benefit tax charge and gets the full amount of child benefit.
She can also claim the difference between higher rate and basic rate tax relief on the gross contribution which increases her basic rate tax band by £1,000 (20% of £5,000) so the amount of tax on the £5,000 reduces from £1,946 to £1,746. Maria has a total saving of £824 (£624 child benefit and £200 in income tax).
The benefit of pensions for the whole family
Pension contributions don’t need to stop when the individual can no longer contribute for themselves. Individuals who are still working but who have lifetime allowance or annual allowance issues may also want to consider the benefits of pensions for family members.
The information provided is based on our current understanding of the relevant legislation and regulations and may be subject to alteration as a result of changes in legislation or practice. Also it may not reflect the options available under a specific product which may not be as wide as legislations and regulations allow.
All references to taxation are based on our understanding of current taxation law and practice and may be affected by future changes in legislation and the individual circumstances of the investor.