Have you thought about your child’s long term future? Financial planner, David Vaughan, has some food for thought when it comes to investing in your child’s future. His latest blog shows us all why putting money away for your child’s pension now, could lead to big returns when your child reaches retirement age.

There are many ways to save for your child’s future, but stakeholder pensions are becoming an increasingly popular and tax-efficient choice.

The magic of compound returns

By starting young, the pension fund will have longer to grow – with spectacular effects.

When money is invested you earn a return on your capital. The following year you earn a return on your capital, plus the previous year’s return.  Over a long period of time this makes a huge difference.A one-off contribution of £800 at birth could grow to £44,586 by the time the child reaches 70, assuming an investment return of 6% per year (after costs) and basic rate tax relief at 20%.

Using the same assumptions, a regular contribution of £20pm from birth until age 18 could result in a pension fund worth £153,516 at age 70.

Can the child get tax relief?

Yes. Despite not being a taxpayer themselves, contributions of up to £2,880 per year to a pension attract tax relief – effectively adding an additional 25p for every £1 invested.  The pension needs to be set up by the child’s parent or guardian, however anyone can contribute. It can therefore be a great way for grandparents to pass on money to future generations.

How do stakeholder pensions work?

Contributions to a stakeholder pension can be made on a regular basis (starting at £20 per month) or lump sums can be paid in as and when.  The maximum contribution is £2,880 per year which is then topped up to £3,660 with tax relief.  This money is then invested in a tax efficient environment until the child reaches retirement age.

What are the downsides?

Money invested in a pension is effectively locked away until your child reaches the minimum pension age (currently 55, but likely to increase). This means that they cannot go on a spending spree at age 18 (which you might consider to be a good thing!).

As with all investments, the value of the pension fund can fall as well as rise and returns could be lower than expected.  It is important to select a fund that is exposed to a level of risk that you feel comfortable with.

Saving for 4 years can be better than saving for 40…

This sounds crazy, but highlights the magic of compound returns.  Saving a fixed amount into a pension fund during the first four years after birth could result in a higher pension fund at age 70 than savings the same amount for 40 years between ages 30-70.

Assuming an investment return of 6% per year after costs and basic rate tax relief of 20%, paying £800 per year into a pension during the first four years of a child’s life could result in a pension fund worth £204,704 by their 70th birthday.  Saving the same amount each year from age 30 to age 70, using the same assumptions, could result in a pot worth £165,048.

Make your child a millionaire…

Taking things one step further, a pension fund of over a million pounds could result from contributions of just £2,880 per year for the first six years of a childs life (assuming 6% per year investment returns after costs and basic rate tax relief on contributions at 20%).

Obviously, this makes no allowance for inflation, meaning that unfortunately a million pounds in seventy years’time is unlikely to be worth the same as a million pounds today. Nonetheless, it will still be a substantial pot of money that could help enhance your child’s standard of living in retirement.

The information contained within this article is for information only and does not constitute financial advice. The value of investments can fall as well as rise, returns could be lower than expected and you could get back less than you originally invested.