Why you should set up a pension for your children

When you set up a pension for your children, the power of compound interest will provide a huge boost to their savings by the time they retire.

Families thinking about how to save and invest most efficiently during 2020 shouldn’t overlook pensions for children. Many people don’t realise that in addition to their own pension contribution allowances they can put money into someone else’s savings. And even if the recipient is a non-taxpayer, as most children are, they’re still entitled to tax relief on the contribution.

Investing £3,600 a year, the maximum allowed, on behalf of a child will cost you only £2,880. The provider you choose then claims an additional £720 from the taxman to top up your contribution.

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Setting up a pension for your children might seem odd, not least because there’s a good chance you won’t be around to see them cash it in. But HM Revenue & Customs said last year that 60,000 families have opened pension plans for kids.

The key argument in favour of such arrangements is the power of compound investment returns over the long term. If you pay the maximum into your child’s pension each year until they turn 18 and the plan achieves a return of 5% a year, they’ll have a pension fund worth £1m by the time they reach age 64.

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The downside to pensions is that they’re inflexible. Under current rules, you can’t cash in a pension until the age of 55 and this limit is due to increase over time as the state retirement age creeps up.

So all the savings you’re putting by won’t be available to help children with financial priorities early in their adult lives: the cost of further education, buying a first house or starting a family, say.

Nevertheless, those priorities are exactly why many people don’t get round to starting a pension plan until later in life. Even among occupational pension schemes, opt-out rates are much higher among younger people.

And since pension saving works best the earlier you start, taking this worry off your children’s hands could prove very useful indeed.

Will the rules change?

One caveat is that future governments could change the rules so that pension saving becomes less tax-efficient. It’s now also much easier to pass on pension savings to your heirs. So one alternative to setting up designated plans for children is to maximise your own contributions in order to increase the chances of there being money left over.

If you die before 75, your heirs will usually inherit what is left of your savings free of tax; even after age 75, you can still bequeath pensions cash, though it’s likely that tax charges will be payable.

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