Planning for retirement and creating security for children are two key goals in financial planning. But many people put off retirement planning until they are well-established in their careers and possibly already have families. If you start contributing to a pension later in life, it may be difficult to regain lost ground.
Did you know that pensions can be set up for anyone, even a child? If your child already has several years’ worth of pension contributions behind them by the time they turn 18, they will have a major head start in life.
So, what are the main benefits of setting up a personal pension or a Junior SIPP (Self Invested Personal Pension) for your child?
Tax Relief
Your child can receive tax relief on their contributions even if they have no income and do not pay tax.
There are, of course, limits to this. Without relevant UK earnings, the maximum gross contribution into a pension is £3,600 per year. This means that you pay in £2,880, and HMRC credits a further £720 (20%) in tax relief. However, the levels, bases of and reliefs from taxation may be subject to change.
Pension funds also grow free of most taxes, which means that they can build up more quickly than non-tax advantaged investments.
Under current rules, it’s possible to withdraw 25% of your pension fund as a tax-free lump sum from age 55 onwards. However, rules can change between now and when your child retires. The minimum retirement age is already set to increase to age 57, and subsequently 58.
Despite the limitations, pensions are one of the most tax-efficient investments that you can set up for your child.
Time in the Market
There are thousands of investment options available for your child’s pension. Even for a relatively small pot, it’s worth diversifying the funds to avoid concentrating too much risk in one area. If you choose a multi-asset fund, this is taken care of for you by the fund manager.
Given the long investment timescale, it’s a good idea to take some sensible risks with the fund. This doesn’t mean investing in high risk assets, but opting mainly for equity based funds that will fluctuate more than cash or bonds. Over the longer term, equities tend to produce higher returns than other asset classes, providing you can wait out any short-term volatility. However, higher returns are not guaranteed.
Compound growth can help to supercharge your child’s investment returns. This means that they don’t only receive returns on their original capital, but also on any growth or income that has been reinvested.
Regular contributions can also benefit from pound cost averaging. Market timing is one of the risks of investing – there is always the chance that the market could fall just after you have invested. By investing monthly, you buy in at both high and low points. When you buy low, you acquire more shares for your money, boosting your eventual fund value.
Considering that a child’s pension may be invested for 60 years or more, they could truly see the benefits of long-term investing.
Teaching Money Skills
If your child reaches adulthood with some knowledge of money and investing, this will be a huge advantage. You can involve them in the decisions and teach them the value of long-term planning.
Investment literacy in the UK could be better. You do not need to be a fund manager or an economist to understand the basics of investing, but many people are intimidated by the concepts. If your child has a working knowledge of financial markets, even at a basic level, this should give them confidence to make their own investment decisions later.
Financial Security
Currently, most working age people do not have access to a defined benefit pension, and will probably accumulate multiple pots over the course of their working lives. Financial security in retirement cannot be taken for granted – it is something that must be planned for and, even then, is not guaranteed.
By the time your child reaches adulthood, it’s possible there will have been significant changes to the State Pension, public sector schemes, and workplace pensions. Setting up a pension for your child means that they will have a good start towards a secure retirement, regardless of the pension landscape at the time.
Building a Legacy
If you are concerned about Inheritance Tax (IHT), making contributions to a child’s pension can help to reduce the liability. Annual gifts of up to £3,000 per year, or regular gifts from surplus income are immediately outside your estate for IHT purposes.
Pension funds are also not subject to IHT, and can be passed through the generations tax-efficiently.
While pensions are not intended for IHT planning, they can be useful for this purpose.
Levels and basis of tax relief may be subject change and their value depends on the individual circumstances of the investor.
Risks and Limitations
There are a few potential downsides to contributing to a pension for your child, for example:
- They will have no access to the money until they reach retirement age. This means that pensions can’t be used for education costs, home deposits, or financial emergencies.
- The money will be subject to investment risk and the value may rise or fall. You could hold a pension fund in cash, but inflation would quickly erode the real value.
- Pensions legislation could change in the future and some of the advantages mentioned might no longer apply.
- Contributions are limited and tax charges can apply for over-funding a pension.
Other Options
If you are looking to save for a child, there may be other options that suit your requirements, either instead of, or alongside a pension. Examples include:
- A Junior ISA – this could be the solution if you want your child to have access to the money at age 18.
- A child’s savings account – suitable for shorter-term savings. Remember that if parent-funded savings accounts earn more than £100 of interest each year, the income is taxed as if it belonged to the parent.
- Premium bonds offer tax-free returns in the form of regular prizes. This can add an element of excitement, although there is no guarantee that your child will win a prize.
- A friendly society plan – contributions are capped at £25 per month and investment choices are limited, but returns are tax-free providing the plan is held for at least ten years.
- A trust fund – generally used for larger sums where IHT planning is a key aim. Trusts can be complex and it’s worth seeking advice.
The content in this article was correct on 29/03/2023.
Past performance is not a guide to future returns and you might get back less money than you have invested.
You should not rely on this article to make important financial decisions. Teachers Financial Planning offers independent financial advice on savings, pensions, investments, mortgages and mortgages for teachers and non-teachers. Please use the contact form below to arrange an informal chat with an adviser and see how we can help you.