Give your child £151,000 - for free!

by Jane Baker on 31 July 2009  |  14 comments
Tweet

It's now possible to build a £151,000 nest egg for your child - using only Government money and legal tax breaks!

There's no question the government is very keen to free itself from its colossal pension responsibilities. That's why new measures brought in over the last few years are supposed to make pensions a lot more accessible and encourage us all to save.

That's also why children are now allowed a pension all of their very own.

Kids and stakeholder pensions

So, did you know you can now set up a stakeholder pension for your kids? In the old days, a pension saver needed to have earnings before they could open a pension, but this is no longer the case. This means you now can save on behalf of your children pretty much from the day they're born.

How much can you save for your kids?

You can save up to £3,600 gross each tax year into your child's pension. But this amount includes the tax relief they'll get back from the government.

What's tax relief? When anyone (not just children) pays money into a pension scheme, they will get some tax back from HM Revenue & Customs (HMRC), which will then be popped into the pension pot alongside their own contributions.

If you're a non taxpayer (as children usually are) or a basic rate pay taxpayer, you'll enjoy 20% tax relief based on current rates. This means for every £100 you pay into the pension, HMRC will add a further £25. So, a total of £125 will be invested in the pension even though it has only cost you £100. (Higher rate taxpayers get 40% tax relief.)

I mentioned that the £3,600 maximum gross annual contribution included 20% tax relief. In other words, the maximum net contribution (i.e. before tax relief has been added) you can pay into your kid's pension out of your own pocket is £2,880 a year (£3,600 minus 20%) or £240 a month.

So, for that £2,880 investment, your child gets £3,600 put in their pension pot. It's simple, really....

Is it really necessary to start your child's pension this early?

No, it's not necessary... but the sooner you start, the better. Pensions love nothing more than decades and decades in which to grow. If you open a stakeholder pension before your child's 1st birthday, it could stay invested in the stock market for 65, or even 70 years, before they reach retirement. State retirement age will be pushed back to 68 from 2044, so it's entirely feasible that children born now may not retire until they reach 70.

This kind of timescale can work wonders for the value of a pension pot because your child can take advantage of compound growth over many years, turning their contributions into a fortune.

For instance, if a contribution of £240 was paid into the pension every month from birth right up until your child's 70th birthday, the pension pot could potentially be worth £954,000. That's almost £1 million!

Sounds crazy I know.

But still, that's a lot of money. Here are the assumptions this calculation is based on:

• Contributions increase by national average earnings which is assumed to be 2.5% a year,
• The pension pot grows at 7% a year,
• 20% tax relief is added to each monthly contribution,
• Maximum stakeholder pension charges of 1.5% for the first 10 years, and 1% every year after that, are deducted,
• The value is shown in today's prices which takes inflation into account at a rate of 2.5% a year.

Of course, I hardly need point out that if the pension fund falls short of the 7% annual return, it could be worth considerably less than a million pounds at retirement. And £240 a month may not be an affordable contribution level. But, nevertheless, you can easily see the benefits of compound growth over multiple decades.

Can I save for my kids without spending any money myself?

Yes. Simply invest your Child Benefit in a pension for your child.

In the current tax year, Child Benefit is paid at a rate of £20 a week for your eldest or only child, and then at a rate £13.20 a week for each of your other children. The payments, which are usually paid every four weeks, are tax-free but they aren't means-tested.

Perhaps £20 a week doesn't sound like much to you, but this could be turned into a monthly pension contribution of £108.33 once 20% tax relief has been added. If you saved this amount every month from birth until your child is 16, this could generate a pension pot worth £151,000 by the time he or she retires at 70.

(This calculation is based on the same assumptions shown above. It's also assumed that Child Benefit increases at a rate of 2.5% a year.)

That's a pretty decent pension pot, given that you haven't shelled out any extra money yourself, and contributions stop entirely when your child is 16. In an ideal world, your kids would continue to pay into the pension themselves once they start earning to give them an even better standard of living once they retire.

I think this is a great way of giving your children a financial head start without breaking the bank.

But, on a final note, we've been so busy thinking about pensions for the kids, make sure you don't forget about your own! Find out how to pick your first pension.

All pension fund values are provided by Legal & General's stakeholder pension calculator.

More: How to pick your first pension | Give your kids a £10,000 nest egg