Child Trust Funds

Child Trust Funds (CTF) went live on 6 April 2005 and are available to each child born on or after 1 September 2002 who lives in the UK and for whom Child Benefit is received. Essentially, they are like an ISA for children, a tax-free vehicle which you can use either for savings or investments.

Family and friends of the child, and the children themselves when older, can make additional contributions of up to £1,200 a year between them. Children will not be taxed on any income and gains they make on the investments in their CTF account.

The government also helps out too, making an initial contribution when the child is born and a second one when they reach the age of seven. Initial CTF vouchers for £250 are automatically sent to the Child Benefit claimant for each newborn child, usually the parent, and these can be used to open a CTF account. (If your child was born between 1 September 2002 and 5 April 2005, your voucher should have been slightly more than £250 to compensate for the interest you could have earned.)

Poorer families, who have claimed Child Tax Credit and whose household income is less than £13,480, will receive a further £250 from the government, making £500 in total.

The second government contribution, when your child reaches the age of seven is expected to be the same amount as the initial contribution, although this has yet to be formally decided upon.

So what's the catch?

Well, there's two. No money paid into a CTF can be drawn out until the child's 18th birthday and from that day the money will belong to them, so they'll be able to do whatever they want with it.

What can you invest in?

It's up to the parent(s) to choose what sort of CTF account to open. There are three basic types:

1. A savings account, which pays tax-free interest.
2. A stakeholder account, which invests in a fund that buys shares in a range of companies. When your child is thirteen, this money is gradually moved into lower-risk investments until it's all in cash at eighteen, in order to avoid a stock-market crash in the last five years of the account. The account must have charges of no more than 1.5% a year, and the minimum additional contribution is £10.
3. A shares account, through which you can buy shares in individual companies. At the time of writing, there were dozens of companies offering one or more of these types of CTF account. Bear in mind that you can change CTF accounts whenever you like, although in the case of stakeholder and shares accounts there may be costs for doing so.

Initial reports suggest that many parents are mostly opting for the savings option. It's easy to see why. You know what rate you're getting and the fund should grow, albeit at a slow pace, each and every year.

However, here at the Fool, we prefer the stakeholder and shares routes. Although these funds are undoubtedly more volatile, over the course of 18 years they are likely to provide a higher return. In fact, over periods of 18 years, shares have historically outperformed cash well over 90% of the time.

Fools who feel comfortable with the concept of investing are more likely to favour the shares option rather than the stakeholder one. The latter is essentially an index tracker, but one that costs up to 1.5% a year, rather than the more usual 0.5%. Over the course of 18 years, this additional 1% a year will reduce your overall return dramatically.

Finally, note that if you haven't opened a CTF account within twelve months of receiving the voucher, the HM Revenue & Customs will automatically open a stakeholder one for you. You'll be free to move it to another provider afterwards if you want though.