Ask Sindie: Two years old and he's getting a pension

A grandfather asks about the tax rules on setting family money aside

Q: It might sound a bizarre question but is it possible to set up a pension for my two-year-old grandson?

I have quite a decent pension and can spare a small sum each month. So far, I've put around £4,400 into a normal savings account, but a bank adviser said he thought it was possible to switch it to a pension.

Is this the case? If so, can I also keep on making other contributions to it without affecting my own pension?

W J, Newcastle

A: Your grandson looks set to be one lucky lad.

The short answer to both your questions is "yes", but there are some points to check before you go ahead.

Happily, contributing to a pension scheme for your grandchild won't have any impact on your own entitlement; this will simply carry on as before.

In fact, the only limits to your finances are the sums you can invest on behalf of your grandson.

Although you've got a considerable choice of funds to choose from - a standard personal pension, self-invested personal pension (Sipp) or stakeholder personal pension - the best option is probably the low-cost stakeholder, says Justin Modray of independent financial adviser (IFA) Bestinvest. "The annual charge is no more than 1.5 per cent," he points out, and these schemes are easy to understand.

While Sipps and standard personal pensions offer to invest your money in a greater variety of ways - in commercial property as well as shares, for example - they tend to carry higher management and administrative charges.

However, there are limits on how much you can put into stakeholders.

You can contribute up to £2,808 in each tax year, which is then topped up by tax relief from the government to make a maximum of £3,600 invested in any financial year on your grandson's behalf.

To this end, make sure no other family members are seeking to make similar contributions into the same pension plan. If you don't, you could end up breaking tax rules by overpaying, warns Tom McPhail of IFA Hargreaves Lansdown.

You need to be aware of plenty of other restrictions too.

Your grandson won't be able to touch the money until he is at least 55 years old - a barrier that may rise during the next few decades as successive governments legislate to change it. At the moment, the age limit is 50; it is going up to 55 in 2010.

So any money you put into the pension now cannot be touched - even in an emergency.

"You do get the tax relief on your grandchild's investment but - for whatever reason (omega) you lose the flexibility if you change your mind," says Mr Modray.

You can put a monthly sum into the stakeholder or make a yearly deposit - as long as you stay within the £2,808 rules. That works out as a maximum of £284 a month.

To get all the tax relief going, Mr Modray suggests making a £2,808 deposit from your £4,400 for this tax year - and doing the same next year.

Stakeholder funds are available from, among others, Norwich Union, Legal & General and Virgin Money, but check the small print to make sure you understand exactly what the pension will do with your money - for example, whether it takes a low- or medium-risk approach to investing in shares.

If you have second thoughts about a pension, you could instead consider putting up to £1,200 a year into your grandson's child trust fund.

Alternatively, if you carry on saving into a regular account for him, make sure he pays no tax on the interest by filling in form R85 and handing it to your bank or building society.

If you need help from our consumer champion, write to Sindie at The Independent on Sunday, Independent House, 191 Marsh Wall, London E14 9RS or email sindie@independent.co.uk. We cannot return documents, give personal replies or guarantee to answer letters. We accept no legal responsibility for advice given