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21 October 2002

Investment Week
Investing for Children

While there is a massive range of products available for saving on behalf of children - from deposit accounts to Oeics - potential investors need to be aware of all the tax implications.

Saving for your children's future

A new arrival in the family and parents, grandparents, other relatives and friends are full of hopes for the little one and his or her future. They want to put something aside that will make a difference when he or she reaches 18 (or 21, or even 25), goes to university, needs to buy a house or flat, wants to get married, has plans to travel the world or wants to set up in business.

Whatever the reason - many investors want to build up a nest egg to help secure their children's futures.

There are a variety of ways to save money for children, from deposit savings accounts, National Savings or Friendly Society Bonds to funds that invest in the stock market.

Current economic uncertainties mean that deposit savings accounts in building societies and banks continue to be the most popular place for people to save money on behalf of a child. They can be opened by a child over the age of seven (or by an adult on a child's behalf) often with as little as £1 and indeed, despite some low interest rates, for short term savings and accessibility bank and building society deposit accounts cannot be equalled.

Interest rates vary (children's deposit accounts range from 4.1% gross with the Yorkshire Building Society's Happy Kids Account to 5.74% gross with the Cheshire Building Society Black Cat Bond - source Life & Pensions Moneyfacts September 2002).

Over the long term, some deposit accounts may not keep pace with inflation, however, reducing the real value of the capital. Deposit accounts are ideal for short to medium term saving and where investors are likely to be making regular withdrawals.

National Savings Children's Bonus Bonds are tax-free investments that are more suitable than deposit accounts for longer-term saving. They offer a fixed rate of interest (currently 4.3% gross, source Life & Pensions Moneyfacts September 2002), are guaranteed for five years and pay bonuses every five years. Available to anyone under 16, they can be held until the child is 21.

They can be cashed in at any time, however should an investor do so before the end of the first year, no interest will be paid. Basically an investor is tied in for five years in order to obtain the full interest rate offered. Bonus Bonds tend to be fixed at a relatively low rate of interest and require lump-sum investments only, with investment restricted from £25 to £1,000 per bond.

Friendly societies offer savings for children without paying tax on the interest payments or on the eventual payout. There are limits on how much can be invested in these plans - currently £25 per month or £270 per year, with the minimum premium varying from society to society.

Many friendly societies offer a Junior or Baby Bond that offers tax-free returns; while the charges levied can be quite high. More competitive than the National Savings Children's Bonus Bond, the Baby or Junior Bond has a major pitfall, however. If the policy is encashed early the investor will almost certainly get back less than the amount paid in. The minimum term for a savings plan is ten years and the investor is committed to a fixed amount of monthly or yearly savings. However, for those who require more flexible investment with a longer time horizon - such as 15 or 20 years - there may be better options available.

Investing in the stock market is becoming a more popular means of putting money aside for children. For almost every five-year period since 1945, the stock market has outperformed deposit-based investments such as building society accounts.

If an investor is planning to fund their child's first flat or university fees, they are likely to be investing for 10 years or more - and over that sort of period any additional risk that may be incurred should be outweighed by the level of return they can expect to earn.

One of the easiest ways to invest in the stock market is, of course, through a collective fund - an investment trust, unit trust or Oeic (open ended investment company) - where money is pooled and invested with that of other investors. There is a huge choice of collective funds, which, as a result of spreading their investment across a number of companies, are often less risky than might be thought.

The Association of Investment Trust Companies (AITC), in its response last year to the Government's proposed Child Trust Fund, or Baby Bond, recommended that the Child Trust Fund should only allow investment in appropriate collective equity funds.

Daniel Godfrey, Director General of the AITC and Chairman of the Personal Finance Education Group, said: "The Child Trust Fund should be used to encourage inexperienced investors to undertake equity investment, otherwise people will just reach for the option they are most familiar with - a bank or building society - which will limit severely the long term growth potential of the Child Trust Fund. Collective equity investments such as investment trusts are strong long-term performers."

Many investment trust savings schemes have low charges and are a very cost effective and efficient mechanism for saving and some have special savings schemes for children. Over the last 20 years £1,000 invested in the average investment trust would now be worth £11,579 compared with £3,521 in the average UK savings deposit account.

In general, children cannot invest in equities or collective funds in their own right. Usually the investment is opened by an adult and designated in the child's name. The child is the beneficial owner of the shares and the adult retains control of the investment on the child's behalf. The child receives the income and growth on the shares, which are then handed over to them when they reach 18.

There are several tax implications to be considered when investing on behalf of a child and this area should be carefully considered. For instance, the Inland Revenue takes into account the source of money invested for a child if he or she is a minor and unmarried. If a parent opens a savings plan on behalf of their child any income arising from the investment counts as the child's income if it amounts to less that £100 gross per tax year.

If this sum is exceeded, all the income will be treated as belonging to the parent for tax purposes and will be taxed at the parent's rate of tax. In this case, the income would only be treated as the child's once the child reached the age of 18 - or got married if this were earlier.

However, if the investment is made by another party - such as grandparent, godparent, other relative or family friend - the income generated is regarded as belonging to the child and is offset against the child's own allowance limit - which this year is £4,615 (single person's tax-free personal allowance 2002/2003).

Investing for a child over a period of 20 years or so would help to give them a head start in life. When they turn 18 they can have the nest egg to help them fulfil their aspirations - whether it is adventure, career or security they seek.

Sherry-Ann Sweeting, marketing manager of the Scottish Investment Trust
www.ifaonline.co.uk