Whilst the announcement in the Autumn Budget 2024 that pension pots will become subject to inheritance tax (IHT) was unwelcome news for many of those impacted, it has spurred some into thinking about making gifts during their lifetime rather than in a will.

The prospect of potentially high effective tax rates on some pension pots on death may lead some to conclude that it is sensible to withdraw sums from their pension, usually suffering income tax on such amounts, and then making gifts of such amounts or using them to fund life insurance premiums. Where gifts are made then these may be immediately exempt from IHT if they are made from surplus income.

Rather than simply handing over cash to children and grandchildren, some are making contributions directly into tax-efficient accounts like Junior ISAs and pensions. These can allow the gifted funds to grow significantly over decades through the power of compounding, free of tax, potentially creating millionaires of the future from relatively modest annual gifts.

Under current rules, a parent or grandparent can contribute up to £9,000 each year into a Junior ISA and up to £2,880 into a child’s pension, regardless of the child’s earnings. A pension contribution at this level is topped up by HMRC to £3,600, as basic rate income tax is claimed back on the pension contribution. Someone can still benefit from this even if they have not made the pension contribution themselves. Any income and gains are not subject to tax within the Junior ISA or pension pot, maximising the growth.

Time is a key factor in how valuable this can be. This is best illustrated with an example. Let’s assume a grandparent makes the maximum contributions possible to a Junior ISA and pension set up for their newborn grandchild and these contributions were made every year from birth until the child turned 23, when many may start their careers in earnest.

Assuming an annual return of 4%, the Junior ISA would convert into an adult ISA when the child turned 18 and subsequently grow to around £320,000 by the time the child turned 23. The total contributions into the Junior ISA up to this point would have been £207,000. If it was then left untouched, with no further contributions, and invested so it continued to achieve an annual return of 4% until the child reaches 67, the ISA pot could be as much as £1.85m.

By comparison, the pension would reach approximately £105,000 by the time the grandchild reached the age of 23, from total net contributions in that period of £66,240. Assuming no further contributions were made and annual growth of 4%, it could be worth over £607,000 by age 67. If a higher annual growth of 5% could be achieved, then the pension pot could be worth over £1m.

These figures show just how powerful early investing can be. There will usually be an upfront income tax cost to consider for anyone withdrawing sums from their pension and that should also be taken into account when determining the best course of action and the overall potential benefits. However, many may consider it makes sense to incur an upfront income tax liability so they can make gifts earlier and in turn, secure the financial future of generations to come whilst also reducing their IHT exposure.

Related insights