Parents and grandparents are increasingly taking out pensions for their children to kickstart their retirement funds and maximise the tax relief.

In the past 12 months, one in ten personal pensions taken out with Virgin Money has been for children, and half of those were for under-fives.

Your child could end up with a pension fund worth more than £1m by the age of 65 if you invest twice his or her child benefit every month to the age of 20, according to Virgin Money. The figures assume there are no further contributions; the fund would be even bigger if your child took over the contributions once he or she started earning.

The big disadvantage, for the child at least, is that he or she cannot get at the money until 50, rising to 55 in 2010. If you want your son or daughter to access the cash earlier, alternatives such as child trust funds and Isas can be accessed at 18 — but they are not as tax efficient as pensions.

A pension fund can be set up from birth and people who are not earning can contribute up to £3,600 gross a year. This allows parents to contribute on behalf of a non-earning child.

The government pays tax relief of 22p for every 78p you invest, taking the total contribution to £1. You would therefore need to contribute only £2,808 for a maximum gross contribution of £3,600.

If you paid child benefit of £75 a month into a pension until the age of 20, the fund would be worth £43,492 by then, assuming growth of 7 per cent.

If the child made no further contributions, he or she would have a fund worth £583,724 by the age of 65 at 7 per cent growth, which would provide a pension income of £17,500 a year. If the pension achieved growth of 9 per cent, it would be worth £1,683,121 by retirement age.

If parents or grandparents matched the child benefit, putting in a total of £150 a month until the age of 20, the fund would be worth £1,167,508 at 65, assuming 7 per cent growth.

There are other tax perks if you contribute to a child or grandchild’s pension. If the contribution comes from a regular income and does not erode your capital, payments are exempt from inheritance tax.

If the money comes out of your capital, remember that gifts of up to £3,000 a year are also exempt from IHT.

Justin Modray of Bestinvest, an adviser, said: “Many of our wealthy clients contribute to pensions on behalf of their grandchildren because they like the tax perks and they also want to give them a head start.”

He recommends stakeholder pensions because charges are capped at 1.5 per cent for 10 years, falling to 1 per cent. There are no entry or exit charges and you can contribute as little as £20 a month. However, the choice of fund will probably be limited to your pension firm’s schemes or a handful of external funds.

Modray’s favourite stakeholder is from Scottish Widows because you can invest in external funds from Newton, Merrill Lynch and Schroders.

For a wider choice, Paul Ilott of Bates Investment Services, an adviser, recommends personal pensions. He said: “Skandia’s personal pension is more expensive than most, but the attraction of being able to select from a large number of funds is likely to outweigh the cost.”

For more on pensions visit www.timesonline.co.uk/pensions

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