August 2022

When it comes to saving and investing, starting early gives you the best chance of building a bigger pot of money in the long term. With concern growing about how younger generations will provide for themselves financially in later life, is a pension a good way of securing your child’s financial future?

With an estimated £5.5 trillion of assets set to be transferred across family generations over the coming decades, there’s plenty of interest in ways of going about it. The first port of call for older generations seeking to pass money down to younger family members tends to be Individual Savings Accounts (ISAs). Cash and stocks and shares ISAs are popular vehicles, as is the Junior ISA.

But there’s another option that many people may not be fully aware of, and which also happens to tick several important boxes: children’s pensions.

This might sound like an oxymoron, at least at first glance. Look more closely, however, and there are several reasons why opening a pension for a child can make a lot of sense. 

Nuts and bolts 

You can open a pension for your child from the day they are born. They can only be set up and managed by the child’s parent or legal guardian, but anyone can pay into them – for instance, it can be a good way for grandparents to pass on wealth. 

Up to £3,600 can be contributed each year (or, if applicable, up to 100% of the child’s earnings). However, those paying in need only contribute £2,880 because contributions are eligible for basic tax relief from the government of 20%, even if the child doesn’t pay any tax. 

From 18, the child becomes responsible for the policy and can make decisions about how it is invested. They can also choose whether or not they want to begin paying in their own contributions, although others can continue to contribute if they want to. 

A compelling case 

The distance from childhood to pensionable age is one of the reasons why children’s pensions might seem incongruous. Yet it’s that very feature that makes children’s pensions so logical. The long-time horizon enables contributions to be paid into higher-risk investments targeting very long-term growth, as the ups and downs of markets will invariably level out over time. 

Most investment products for children have an investment term of about 18 years, whereas a pension started for a child will be invested for much longer and potentially right up until the point at which it can be legally accessed. 

It almost goes without saying that a sum of money invested for that long, and benefiting from the power of compounding along the way, could generate a very handsome pension pot by the time the child comes to access it. For example, say you contribute the full £2,880 (effectively £3,600) from birth until the child turns 18, and benefit from growth of 5% a year, with profits reinvested annually in order to benefit from compounding. This would produce a pension fund of more than £750,000 by age 57. And that’s without further contributions being paid beyond age 18. 

There are other, perhaps less obvious benefits to children’s pensions too, including tax efficiencies. If the child grows up to become a higher-rate taxpayer they’ll be able to claim tax relief at their highest marginal rate on contributions made to their children’s pension, even if they were paid by parents or grandparents. 

Another is the ability to use a children’s pension as a way of mitigating inheritance tax (IHT) when passing on wealth. That’s because contributions to a children’s pension can fall outside someone’s estate for IHT purposes if they meet certain conditions (such as qualifying as a regular gift made from regular income).

The money paid into a child’s pension can also help mitigate any ‘high-income child benefit charge’ faced by recipients when they become parents. The contributions to the pension can be deducted from the income used to calculate the child benefit charge, with the result of reducing the tax payable. 

Possible pitfalls

As with any product, however, there are some disadvantages to be aware of, including the direct flipsides of certain advantages.

The biggest drawback is that the money invested is only accessible at the same age as other pensions (currently 55, but rising to 57 in 2028). For many parents, the fact that their child can’t access the money until later in life is actually seen as one of the chief benefits, as it means the recipient can’t blow it all when they turn 18. But that lack of flexibility will in some cases be a deterrent, as the money saved up can’t be used instead for other purposes. 

Some parents might prefer to save for their children with an ISA, where the money can be accessed to help with more pressing outgoings earlier in life, such as housing deposits and education.

It’s important to remember too that even when the recipients can eventually draw from their pension, only 25% can be taken tax-free. There’s also always the possibility that pension legislation (such as withdrawal rules or tax details) could change significantly over that time frame, introducing a degree of uncertainty into the process.

Mix-and-match

Those downsides mean that children’s pensions aren’t always the best option. Fortunately, there are several other ways of saving for children, either instead of a children’s pension or alongside one. 

The best known is the Junior ISA, which parents or guardians can open and pay up to £9,000 a year into (under the current allowance) without it affecting their own ISA allowance. One of the key differences is that the child can take control of a Junior ISA from age 16 and take money out of it from age 18, which means they can access and use the savings as they like.

Parents can maintain more control by saving for a child using their own adult ISA allowance. But while this provides more control over what happens to the money, it also uses up the parent’s own annual ISA allowance. 

Banks and building societies often offer children’s savings accounts outside the usual ISA and pension wrappers. With children getting the same personal tax-free allowance as adults (£12,570 in the 2022/23 tax year) as well as the £1,000 Personal Savings Allowance, interest paid by non-ISA cash accounts will almost always be tax-free.

Next steps

The different approaches are potentially complementary, with children’s pensions the longer-term option while other products offer more flexibility. Please get in touch so we can work out the best approach for your family.