Ed Murray: Is your old age secure? Then give next generation the same

A GROWING army of parents and grandparents are cutting through the complexities of pensions to boost the wealth they pass down to their children and grandchildren.

Starting a pension for a child may seem incongruous, but experts point out that not only will it help secure their financial future, it also offers tax advantages for the adult paying into the pension on their behalf.

For many adults, paying into a pension for a child is attractive because it is a way of giving them money safe in the knowledge that it will not be spent long before they ever get to retirement age.

This is a point that Steve Wilson, financial consultant at Alan Steel Asset Management, said was uppermost in the minds of the increasing number of people asking him about helping young family members in this way.

"It is a good way for parents to build wealth for their children, knowing that their children cannot touch it until they are at least 55," said Wilson. "Normally if parents put money away for children then they often have a legal entitlement to it once they hit 18."

Setting up a pension for a child also makes financial sense. Individuals can pay up to 2,880 into the pension on an annual basis and the government will add tax relief of 20 per cent, taking the total contribution to 3,600.

Although more than 2,880 can be put into the pension on an annual basis, no tax relief is available beyond this point. Parents or grandparents may not get tax relief if they pay more than 2,880 into a single child's pension, however if they are considering doing this for more than one child, they can pay up to this limit of 2,880 for each of them.

David Oliver, director at IFA Intelligent Capital, explained: "No child can get more than 3,600 a year (gross) into a pension from all sources, but a parent can invest 3,600 for all of their children."

Not only does the tax relief make investing in a pension for a child an attractive option, but it also offers some inheritance tax (IHT) benefits for the individual paying into the pension.

Funding a pension for a child allows the parent or grandparent to take money out of their estate, without attracting IHT.

There are three possible avenues that parents and grandparents can take to ensure the money with which they fund the pension is not made liable to IHT when they die.

Firstly, there is the annual exemption for gifts of up to 3,000 a year, which means a person can gift a total of 3,000 without incurring IHT on the gift.

In the second instance there is the "normal expenditure out of income" rule.Essentially this means that as long as there was no impact on the parent or grandparent's standard of living from paying into the child's pension, then the money they have put into the pension will not be liable for IHT.

Andrew Tully, senior pensions policy manager at Standard Life, said: "This isn't given automatically and the deceased's executors would need to show HM Revenue & Customs that the gifts were eligible for the exemption. HMRC may require documentary evidence to validate a claim and so the donor should keep adequate records during their lifetime."

Finally, anything that is not protected by these two rules will still be fully exempt from IHT so long as seven years has passed between the gift being made and the donor dying.

Perhaps the biggest benefit of all is the impact that starting early will make to the final value of the child's pension. Were a parent or grandparent to pay 20 a week into a pension from the child's birth until they were 18, the government would add tax relief of 5 per week, making a gross weekly contribution of 25. Leaving the fund to grow on its own, with no further contributions from the age of 18, Tully said it should be worth around 190,000 in today's terms. To reach this figure, Tully has assumed a modest annual investment return of 3.5 per cent, to strip out the effects of inflation.

This would buy a pension of about 13,200 a year based on today's annuity rates (using the example of a single life, level annuity for a man aged 70).

Anyone can pay into a pension for a child, and the pension provider will only need a signature from the child's legal guardian to sanction the creation of a pension in their name. The provider will also ask the person funding the pension to fill out a form detailing that they are not the pension plan holder.

It's not a lot of extra work and it offers those that can afford it an efficient, controlled and tax-friendly way of passing on wealth.