FOOL'S EYE VIEW
Five Alternative Ways to Invest for Your Child

By Jane Mack (TMFJane)
January 11, 2005

Ever since 2001, the Government has been trumpeting the advent of its new Child Trust Fund designed to enable parents and relatives to save for a child's future with the help of a contribution from the Treasury. And this week it has officially been launched.

However, nice idea though it is, the Child Trust Fund is only applicable to children born since 1st September 2002 so what are parents to do if their children are slightly older? It's down to the parents to check out the alternative options for their older children.

There are several methods of saving and investing for children - some of them not as good as others and there are also certain tax pitfalls to be aware of in some cases. But the most important aspects to consider are whether your investment for your child has a particular purpose such as paying for a university education or a deposit for a first home, the length of time you have to invest and the amount of risk you are prepared to take.

National Savings Children's Bonds

These are designed for children up to the age of 16 and can be bought by parents and relatives in batches of £25 up to a maximum of £3,000. They last for five years at a time and interest paid is tax-free with a bonus being paid at the end if the bond is kept for the full five years. At 16, the child takes control of the bond and can reinvest it in a further bond, tax-free, until they reach 21.

The guaranteed interest rates are not great particularly if the bond is cashed in early. For example, the current issue earns just 3% for the first five years with a bonus of 8.44% paid on the 5th anniversary of purchase and no interest is paid at all if the bond is cashed in before the end of the first year. Whether the tax-free element is worth considering is a moot point as children don't usually pay tax anyway, although see below when it comes to affecting parental contributions to other methods of saving.

Children's Deposit Accounts

These operate like ordinary savings accounts although before the age of seven the account must be in the parent's name with the child's initials attached. Note that any contributions to the account by the parents which generate interest of more than £100 a year each will be treated as the parental income and will result in the relevant parent paying tax on it.

Interest earned on contributions made by the child or friends and relatives is not subject to this rule. Children have their own personal allowance in the same way as adults do so, as long as any income doesn't exceed the allowance (currently £4,745 for the 2004/5 tax year), any income received will be free of tax. To that end, parents should make sure they ask for Form R85 (an Inland Revenue form) when opening an account for their child to ensure the interest is automatically paid tax-free.

Friendly Societies

Children's bonds offered by Friendly Societies benefit from tax-free status on annual returns and also when the scheme matures and pay out. Parents or relatives can pay the premiums on the child's behalf subject to a maximum of £25 per month or £270 per annum for each child to qualify for the tax benefits so contribution levels are low. They also need to be taken out for a minimum of ten years.

Unfortunately, although contributions are invested in the stock market, these products are essentially endowment policies and many of them have extremely poor track records not least because they generally have high charges and set-up costs.

Unit Trusts & Investment Trusts

Investment in the stock market via unit trusts or investments trusts should not really be considered unless the money will remain invested for at least five years. Although the stock market can be volatile over the short term, over the long term it generally produces better returns than any assets like cash and bonds. The simplest and cheapest form of stock market investment is an index tracker. Ideally, any dividends should automatically be reinvested in the fund.

Children can hold units in a designated account, although it is registered in the name of the parent or other guardian, until the child reaches 18 when the fund becomes theirs. Investment gains can be offset against the child's annual Capital Gains Tax allowance (currently £8,200 in the 2004/5 tax year - just as it is for grown-ups).

Stakeholder Pensions

As there are no age limits on stakeholder pension plans, a new born baby can have a stakeholder pension taken out in their name and reap the benefits of 22% tax relief from the Government. Currently the maximum annual investment is £3,600 including the Government' s 22% tax 'contribution' of £792.

Although the tax relief is a major plus point, bear in mind that stakeholder pensions lack flexibility. Under current rules, the child can't get access to his pension fund until he's at least 50 years old and he'll have to use it to buy an annuity by the time he reaches 75. New pension rules come into effect in April 2006 however and of course the legislation could change several times more before your child takes his pension! Nevertheless, if the full amount is invested each year for the first 18 years of a child's life, the fund could grow into a substantial sum by the time he's 50 (even with no further investment from the age of 18).

On the whole, investments for children should generally be made via the stock market, preferably via a cheap index tracker, and the money should remain there for at least five years and preferably for much longer. While some of the schemes outlined above offer tax advantages, they can be inflexible and/or costly. So choose carefully!

Find out more about Index Trackers and Saving For Children

With thanks to Chartwell Investment for their helpful input.