According to Skandia, something as simple as using extra pension income to contribute into a pension for their children can make a significant difference to the value of the inheritance parents can leave behind. 

Funds held in capped drawdown, an option to draw an income for life, with an annual limit, without having to purchase an annuity, can be very inefficient from a death benefit perspective.

Adrian Walker, Skandia’s pension expert, said: “Utilising surplus pension income to fund a child’s pension will help boost the value of the inheritance parents pass on to their children.

“A pension remains one of the most tax efficient forms of saving and it will ensure the child is better positioned to avoid any future retirement income problems.

Those in retirement know better than anyone how important it is to have adequate savings, so what better way for parents to provide for their children than to ensure their long term security through opening a pension for them.”

According to the report, if the capital is to be paid to the children as a lump sum when the parents die, it will be subject to a 55% tax charge.

This means the children will only receive 45% of the value of that fund when the parent dies.

If a key aim of the parents is to protect their children’s inheritance, and they are not utilising their maximum available income, it would make sense for them to use this surplus income for some proactive estate planning.

Skandia says that there are many ways in which parents are able to pass on surplus income to help their children, such as paying off their debts or reducing their mortgage.

However, a tax efficient way of passing on wealth is by making a pension contribution for them.

Any income tax paid by the parent on the income they take is usually negated by the fact that contributions made on behalf of their child can be grossed up at the child’s highest rate of tax.

Putting money into a pension means the parent is securing the long term financial future of their children, especially where a child’s earnings may limit the amount they can currently save personally for their future.

The following demonstrates how effective it can be from a tax and estate planning perspective to utilise surplus income from a parent’s pension to fund a child’s pension.

In this example the parent currently has a drawdown fund of £300,000

If the parent takes no action, and they die 10 years from now, their drawdown fund could have grown to £495,000*. This would leave an inheritance of £222,750 for the child after 55% tax has been paid.

If the parent instead starts to take £10,000 a year from their drawdown fund to contribute into their child’s pension, although the parent will suffer 20% income tax, the child will receive 20% tax relief (assuming both are basic rate tax payers).

So if the parent dies 10 years from now, their drawdown fund could now be worth £361,000.

This would leave a lump sum of £162,450 for the child after 55% tax has been paid.

In addition, the contributions paid to the child’s personal pension could be worth £135,700 after 10 years, bringing the total value of the child’s inheritance at that point in time to (£162,450 + £135,700 =) £298,150.