Passing money to future generations in a tax efficient manner

Saving for a decent pension to live on is expensive. Depending on how you draw your pension, to provide an income of £30,000pa from age 65 you would currently require retirement savings of around £660,000 if you are in good health, but that is without increases to protect from inflation.

It is possible for you to make a pension contribution on someone else’s behalf. So, one-way parents or grandparents can ease the burden for their children and grandchildren is to kick start their retirement savings for them.

HMRC treat the contributions as if they had been made by the child/grandchild. Assuming the child/grandchild has no earnings, the maximum gross tax relievable contributions that can be made are £3,600 each tax year, but f they do have earnings, the maximum gross tax relievable contribution is 100% of those earnings, up to £40,000pa. However, pension contributions are paid net of basic rate tax relief, currently 20%, which is reclaimed from HMRC by the pension provider.

How are these contributions treated for inheritance tax purposes?

The contributions are classed as gifts for IHT purposes, but the usual exemptions apply. This means that £3,000pa can be paid as an exempt gift and this more than covers the £2,880 net contribution payable if your child/grandchild has no earnings (£3,600 minus 20% tax relief). However, if you can show that any regular contributions can be paid out of your income without affecting your standard of living, they would be okay without the need to rely on the £3,000pa exemption, which could be used as well.

If none of the exemptions apply but you survive for at least 7 years after making a contribution, that contribution should be IHT free via the potentially exempt transfer route. 

How can you help your child if they are subject to a ‘tax trap’?

If your child is a parent themselves with adjusted net income over £50,000, they could find themselves subject to the ‘child benefit tax-trap’. This means that the child benefit they receive will effectively be reduced by 1% for every £100 they earn over £50,000, up to £60,000 when all entitlement is lost.

Another key area is income in excess of £100,000. Above this level you start to lose your personal allowance at a rate of £1 for every £2 you earn, meaning that once you earn over £125,000 currently, you lose your whole tax-free personal allowance. This is equivalent to paying 60% tax on the portion of income between £100,000 and £125,000pa.

What can you do?

As mentioned above, anything you contribute to a pension on behalf of your child is treated as if they made the contribution themselves. Let’s say you have 2 young grandchildren, for which your child receives £1,820pa child benefit. If your child has adjusted net income of £55,000 they will have been caught in the ‘child benefit tax trap’ and pay an additional tax charge equivalent to half of the benefit.

If you were to make a pension contribution for them of £4,000pa, basic rate tax relief increases the contribution to £5,000 and this would be deducted from your child’s income meaning they would no longer be in the trap.

This is because the gross contribution of £5,000 brings their income down to £50,000, which means they would avoid the child benefit tax charge and get the full amount of child benefit. Not only does this mean they are £910pa better off, but they can also claim the difference between higher rate and basic rate tax relief on the gross contribution which comes to £1,000 (20% of £5,000).

As another example, if your child is lucky enough to earn say £110,000, they will effectively be paying 60% tax on £10,000 of their income. However, if you make a pension contribution for them of £8,000, this is grossed up to £10,000 by tax relief and deducted from their income. The result is £10,000 lower taxable income, saving them a further £4,000 in tax.

What does this mean for you?

If you are concerned about inheritance tax and how much tax your children will have to pay on your estate in the event of your death, this could be a useful way to help your children/grandchildren save tax now and save for their retirement, as well as removing capital from your estate for inheritance tax purposes. This means there could be less inheritance tax to be paid on your estate, which is currently taxed at a rate of 40% over your available nil rate band.

Get in touch

I hope that this has given you food for thought with regard to the transfer of wealth. The key aspects are to have a clear understanding of what you may need for yourself, then to consider how best to use your assets to mitigate future IHT and maybe help your family now.

If you need any guidance on planning for your future, advice on making gifts (including using pensions, the really tax efficient gift), please get in touch and we can talk about you.

Lee Smythe MSc