Third party pension contributions and children
This briefing sets out the points to consider when third parties pay contributions to pensions (including for children), the tax treatment and possible uses in financial planning.
Third party contributions can be made by someone other than a pension scheme member.
- Third party contributions are treated as if they had been made by the individual member and are subject to the same restrictions on tax relief based on the individual member’s circumstances.
- The individual member receives the benefit of tax relief on the third-party contribution – not the contributor.
- Third party contributions are treated as a gift for Inheritance Tax (IHT) purposes.
- The use of third-party contributions can be a valuable part of financial plans for spouses/civil partners and for IHT planning.
- Third party contributions
- Treatment for Inheritance tax purposes
- Contributions for spouses/civil partners
- Contributions for family members – IHT planning
- Contributions for minors – IHT planning
Third party contributions
These can be paid on behalf of a pension scheme member (subject to the pension scheme rules or pension provider permitting this). In these circumstances it is treated as if it had been paid by the member which means that the member (rather than the contributor) receives any relevant tax relief. It also means that the amount which will receive tax relief is subject to the same rules as member individual contributions (so generally limited to £3,600 per annum or net relevant earnings if higher).
Treatment for Inheritance tax
The individual making the contribution is treated as having made a gift for IHT purposes to the member. This could be covered by an exemption (spousal/civil partnership exemption, normal expenditure out of income or annual gift allowance of £3,000), but if not, it will be treated as potentially exempt transfer.
If a new pension plan is being established it must be the individual member, and not the contributor, who makes the application for the plan. If that individual is a minor then a parent or legal guardian must make the application.
Third party funding of pensions can be used in three key ways as part of a financial plan:
1. Contributions for spouses/civil partners
Ramesh is a higher earner with a fully tapered annual allowance. His wife Priya has a more modest income of £30,000 per annum and minimal pension provision. After funding his own pension with £10,000 Ramesh can consider making contributions of up to £30,000 a year to Priya’s pension including Priya’s current contributions. Priya pays 5% personal contributions which her employer matches.
Ramesh can therefore contribute of up to £28,500 gross (£30,000 minus the spouse’s personal contributions of £1,500). Ramesh pays £22,800 and the provider adds £5,700 tax relief. Note, gifts between spouse’s and civil partners are generally exempt from IHT.
2. Contributions for family members for IHT planning
Samuel is 73, has Inheritance Tax (IHT) concerns and a large surplus income from his investment portfolio and defined benefit pension scheme income. He has two grandsons, Daniel and Adam, both in their early twenties. Daniel is a basic rate tax payer and Adam is a higher rate tax payer.
Making regular pension contributions to a personal pension for Daniel and Adam will allow them both to use their income for more immediate needs. Basic rate relief will be added to the contributions and, if the contributions are made out of surplus income, they should qualify for the normal out of income exemption and be exempt from IHT. Adam can also claim higher rate relief through his self-assessment tax return which means his tax will be reduced so increasing his take home salary after tax.
3. Contributions for minors with an IHT saving
Emilia is 65, has Inheritance Tax (IHT) concerns and two years ago became a grandmother to twins Ariana and Nico. She wants to put aside some money for the twin’s future but wants them to benefit in later life rather than having free access at a younger age. Emilia has not and does not use her small gift allowance of £3,000.
Making an initial personal pension contribution of £2,880 for both Ariana and Nico will mean that £3,600 is invested for each of them. Although the twins have no net relevant earnings they can still benefit from basic rate tax relief through relief at source but the gross amount of contribution is limited to £3,600. The initial contribution uses this year’s and most of last year’s small gift allowance. Going forward Emilia will make contributions of £1,500 for each twin every year which means £1,875 will be invested for them. This level of contribution is affordable to her now and in the future. The twins’ parents (Emilia’s daughter and son-in-law) Bella and Luca will need to propose for the personal pensions and complete the paperwork. In effect the pensions will be held in bare trust for the twins until they reach the age of majority when they can make their own investment decisions, but not access the funds.