Why third-party pension contributions could be a vital part of intergenerational wealth planning

Intergenerational wealth planning is about making sure that your financial plan creates security for the whole family, now and after you are gone. Passing down your wealth to your children or grandchildren is likely a big part of that.

As such, you may be concerned that FTAdviser reports Inheritance Tax (IHT) receipts rose by £1 billion in the 2022/23 tax year, compared to the previous 12 months.

Finding ways to combat this potential increase in IHT and pass on more of your wealth may be a crucial part of your intergenerational wealth plan. Fortunately, there are several ways to do this including lifetime gifting, using trusts, and making third-party contributions to a child or grandchild’s pension.

People often overlook the last option, which can be an effective way to start passing on some of your wealth now. It may also benefit your child or grandchild more than a cash gift or inheritance, especially during the cost of living crisis when many people are finding it difficult to make regular pension contributions.

Read on to learn how third-party pension contributions work and why they could be an important part of your intergenerational financial plan.

26% of large businesses report an increase in pension opt-outs

The cost of living crisis is making it more difficult for many people to meet financial obligations and plan for the future. Finding ways to cut spending can relieve some of this pressure and an increasing number of people are reducing pension contributions to save money.

Indeed, PensionsAge/em> reports that more than a quarter of large companies have seen an increase in pension opt-outs.

However, if your child or grandchild is among those stopping or reducing their pension contributions during the cost of living crisis, they could be missing out on vital opportunities to build their savings for the future.

They may not realise the long-term effect this could have on their lifestyle in retirement. However, the good news is, if you make contributions on their behalf, you may be able to stop them from falling behind with their retirement planning.

It may also have other benefits for both parties. Here are three reasons to contribute to your child or grandchild’s pension.

1. They may benefit from tax relief

Lifetime gifting is one way to pass your wealth on to future generations now, though you may want to consider making third-party pension contributions instead because the recipient could benefit from additional tax relief.

Normally, when you pay into a child or grandchild’s pension, the contributions are treated as if they made them themselves, meaning they receive 20% tax relief at source. They may also be able to claim additional tax relief if they are a higher- or additional-rate taxpayer.

That means the wealth you pass on to them in the form of pension contributions may be more valuable than a cash gift, as they receive the additional tax relief on top.

These contributions count towards their £60,000 Annual Allowance (2023/24 tax year) – or £3,600 gross if they are not earning – and you may trigger a tax charge if their total contributions, including employer contributions, exceed this threshold.

However, you can still pass on a significant amount of your wealth in this way before triggering a tax charge, and the tax relief means that you maximise the value of the gift for the recipient.

2. They could generate powerful compound returns

Pausing pension contributions now could significantly reduce the size of your child or grandchild’s pension pot when they retire. Unfortunately, it may be too late for them to catch up later in life because they missed out on compound returns.

A study reported by Simply Pensions demonstrates the importance of making pension contributions early and benefiting from these compound returns as much as possible.

It found that if you started saving when you were 21 and stopped when you were 30, assuming an annual contribution of £2,500 and 7% annual growth, you would have £553,000 by age 70. Your total contribution of £25,000 would have grown significantly because of compound interest and reinvested returns.

Now, say that you contributed the same amount each year, with the same annual growth, between the ages of 30 and 70. Your total contribution would be £100,000 but your pension pot would be £534,000 – that’s £19,000 less than if you had started saving at age 21, even though you saved for an additional 31 years.

So, as you can see, saving early is crucial and if your child or grandchild stops their contributions, they may have to make sacrifices in retirement as they may have a much smaller pension pot.

The good news is you can help them stick to their retirement plan by making contributions on their behalf.

3. You may be able to reduce the size of your estate for Inheritance Tax purposes

In his 2023 spring Budget announcement, Jeremy Hunt confirmed that IHT “nil-rate bands” ­– the amount you can pass on without triggering an IHT charge – would remain static. This could make it more likely that your family will face a large bill when they inherit your estate.

They will normally pay 40% IHT on the portion of your estate that exceeds your nil-rate band of £325,000, and potentially your “residence nil-rate band” of £175,000 (if you pass your main residence to a child or grandchild).

Considering the average UK house price was £286,000 in May 2023, according to the Office for National Statistics(ONS), and is significantly higher in the south-east, the value of your estate may be more likely to exceed the nil-rate bands than you realise.

Additionally, you may generate interest and returns on savings and investments so, while the nil-rate bands remain the same, your estate could well increase in value and more of your wealth will be subject to IHT.

The good news is you may be able to use third-party pension contributions to reduce the size of your estate for IHT purposes.

Gifting rules apply to these pension contributions so you can use your annual exempt amount to gift a total of £3,000, which automatically falls outside of your estate for IHT purposes. Any further contributions may fall outside of your estate, provided you survive for seven years after making the gift.

The “gifts from income” exemption may also apply provided the gift:

  • Is regular
  • Comes from your income, not your savings or other sources
  • Does not cause you to make sacrifices to your normal lifestyle.

In some cases, using these additional gifting rules means you can contribute more to your child or grandchild’s pension without triggering a tax charge.

However, it may be a good idea to seek professional advice to ensure that you correctly understand the potential tax implications of making third-party pension contributions.

Get in touch

If you want to explore new ways to make your wealth work for the whole family, we are here to help. Please give us a call on 01276 855717 or email info@braywealth.com today.

Please note

This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.

The Financial Conduct Authority does not regulate estate planning, tax planning or will writing.

A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future results.

The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates and tax legislation may change in subsequent Finance Acts.

Approved by The Openwork Partnership on 26/07/2023