MONEY COMMENT
Tax-Free Saving For Kids

By Cliff D'Arcy
November 2, 2004

National Savings & Investments (NS&I), the government's savings arm, has increased the limit for tax-free Children's Bonus Bonds from £1,000 to £3,000.

These bonds are bought in a child's name and remain under the control of a parent or guardian until the child turns sixteen, when s/he receives the proceeds. If held for the full five-year term, they pay a guaranteed, fixed annual interest rate of 4.45%, compounded. A new issue is released whenever NS&I changes its rates, but these bonds are available all year round. The minimum investment is a mere £25, and you can buy them via Post Offices.

So, what could you expect to get back from investing £3,000 over five years? You earn compound interest of 3% a year, which generates interest of £478. On the fifth anniversary, the bond pays a bonus of 8.44% of your original capital, which comes to £253. So, your tax-free interest comes to £731, which equates to 4.45% a year. When your bond matures, you can roll over the money into a new bond for another five years.

Although these bonds may be attractive to children who are taxpayers in their own right (perhaps thanks to generous parental gifts or an inheritance), there are better deals around for kids who don't pay tax.

For example, here are five Best Buy children's savings accounts found on the high street (sorted by Annual Equivalent Rate, from highest to lowest):

Usually, these accounts are taxed, but there is a way around this. Complete a form R85, which you can download as a PDF file here (fill in page three). This instructs a bank or building society to pay interest on an account without deducting tax. You can only do this if your child earns interest of under £100 per tax year from savings given by a parent (that's £200 per year from mum and dad combined).

Interest earned on money given by other relatives and friends is only taxed if your child exceeds his/her tax-free annual allowance, currently £4,745. Thus, it's worth keeping records of all gifts - or keeping parental gifts separate from other donations.

If you're investing for more than five years, think about something a little racier than cash. For example, you could invest in a cheap, simple stock-market investment that could produce superior returns in the long run. Investing from birth to eighteen is usually long enough for the stock market to beat cash, bonds and other mainstream investments.

Rather than being sucked into investing in heavily advertised but sky-high-charging Baby Bonds® or other iffy child-branded schemes, I'm using a low-cost index tracker to harness the stock market for my children. These articles explain how, given enough time, patient parents can turn small sums, such as weekly Child Benefit, into impressive lump sums.

More: Visit our Saving For Children centre | Invest in an index tracker.