Parents or grandparents can save on their inheritance tax bill and put away more than £1m in their children’s or grandchildren’s pensions by making use of lucrative gifting allowances.

When people die their estate will have to pay 40% inheritance tax on anything above £325,000. In addition to this, they can make use of the new residence nil rate band.

Generally, any gifts made by individuals from their savings are subject to the seven-year rule for inheritance tax purposes. This means that if they die within seven years of making the gift inheritance tax will be due, on a sliding scale depending on how long ago the gift was made.

However, each year every individual can give away some of their money without this tax rule applying.

GIFTING RULES

Each person can give away up to £3,000 each year, moving it out of their estate for inheritance tax purposes.

What’s more, if you didn’t use the allowance the previous year you can use double the allowance in the current tax year. There are other exempted gifts too, including for a child or grandchild’s wedding, but we’ll leave them aside for now.

If parents or grandparents used their annual gifting allowance to contribute to their child or grandchild’s pension, they can make use of the double whammy of Government tax relief and compound interest to hand their offspring a healthy retirement pot. It is important they have this money to spare each year and do not need it to supplement their income.

If each individual gifts £3,000 into a pension in their grandchildren’s names, for example, this is increased to £3,750 with tax relief. This means between a couple each year £7,500 can be put into a pension (see below for the limits on contributions).

AN EXAMPLE OF HOW MUCH A PENSION COULD BE WORTH

Let’s assume a couple want to put away money for their grandchildren. If the couple contributed the full £6,000 each year between them, every year for 10 years, collectively their grandchildren’s pensions would be worth almost £103,000 after tax relief, assuming annual growth of 6%.

However, the nature of pensions is that they are invested over long periods of time, and this means they benefit from the magic of compounding – where you effectively get returns on your returns.

This is particularly the case in this example, as the grandchildren are likely to be young and have a long time until retirement, when they can claim their pension.

This means if the aforementioned £103,000 pot was left for 40 years, with no further contributions, it would be worth a whopping £1.13m, assuming that same 6% annual growth. Even if the money was only left for 30 years, it would be worth £620,000.

What’s more, £60,000 of the couple’s money would have been moved out of their estate, and so no inheritance tax would be paid on it – saving a potential £24,000 tax bill.

WHAT ARE THE LIMITS?

You don’t have to be an adult to have a pension. Children can have a pension opened in their name, and they get tax relief at a 20% rate. However, the rules are the same as an adult: you will only get tax relief on pension contributions of up to 100% of what you earn in any tax year or on £3,600 – whichever is greater.

As most children will earn nothing, they can make use of the basic limit and up to £2,880 can be put into their pension in the current tax year. This will be increased to £3,600 after tax relief – taking it to the maximum limit.

This means if you’re going to use the gifting plan above for inheritance tax purposes, and make use of the full £3,000 a year allowance, you would need to contribute to more than one child’s pension, or contribute to a child and an adult’s pension.

If you are contributing into someone’s pension who is earning money, whether they are a child or adult, you will only get tax relief on pension contributions of up to 100% of what they earn.

For example, if the person in question earns £5,000 in a tax year and you want to contribute £6,000 to their pension, they will only get tax relief on the first £5,000.

If the adult is a non-taxpayer, because they don’t work, for example because they are in education or a stay-at-home parent, then they get the same £2,880 allowance as we talked about for a child, which is topped up to £3,600 after 20% tax relief.

Laura Suter, personal finance analyst, AJ Bell

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