Saving & investing for children – your options explained

If like me you’ve got a bundle of joy to look after it won’t be long before your thoughts turn to how best to provide for your child’s future.

But knowing how best to save or invest for your child can be a bit of a minefield. So here I cut through the jargon and set out what parents’ options are.

Open a children’s savings account – Most banks and building societies offer some form of savings account for children and they operate in much the same way as adult accounts. Having said that, before the age of 7 accounts have to be held in the parent’s name (although earmarked for the child). Children have the same annual personal income tax allowance as adults which means any income/interest earned up to this level is tax-free. Usually bank interest is paid net of 20% tax so parents need to ask for an R85 form when they open the account to ensure gorgeous little Oliver gets his interest tax-free.

But a couple of things to be aware of:

1. Gimmicks – lots of accounts will fob you off with naff toys etc to disguise the poor interest rate on the account. Don’t be fooled.

2. If you're a parent or step-parent and the money you give your child earns more than £100 interest a year, this interest will be taxed as if it were your own. However, if each parent makes a separate gift, they can each use their £100 allowance, thereby allowing interest of £200 to be free of tax. Because of this, if a significant gift is to be made, it would be best coming come from a grandparent or other relative as the £100 rule would not apply.

Pros

• Low risk
• Easy to administer and top-up
• Tax efficient - up to £100 interest per tax year (per parent)

Cons

• Child will gain access at age 7 – but you could always hide the passbook
• Interest rate may not keep pace with inflation – so reducing the real value of your investment

Child Trust Funds – if your child was born between 1st September 2002 and 2nd January 2011 and wass eligible for child benefit you would have got a £250 voucher to invest in a Child Trust Fund (CTF). The Child Trust Fund (CTF) is a long-term savings and investment account and the money cannot be withdrawn until the child is 18 – unless they are terminally ill. All interest/gains are tax free and you can invest up to £4,080 a year into it, via cash or investment funds. More info can be found here.

Pros

• Tax-free
• Free contribution from the Government
• Child can not gain access until they are 18
• Gives some access to investment options other than cash
• Can now be transferred into Junior ISAs

Cons

• Withdrawn by the Government and unable to be transferred into Junior ISAs
• Limited investment amount each year (3,600)
• Limited investment options
• Interest rate on cash holdings may not keep pace with inflation – so reducing the real value of your investment

Junior ISAs - These replaced Child Trust Funds which will be called Junior Individual Savings Accounts. For full details see my post Junior ISAs explained.

Pros

• Tax-free
• Child can not gain access until they are 18
• Gives some access to investment options other than cash
• Can invest up to £4,080 per tax year

Cons

• Limited investment amount each year
• Limited investment options
• Interest rate on cash holdings may not keep pace with inflation – so reducing the real value of your investment

Children's Bonds from National Savings and Investments (NS&I) - NS&I Children's Bonds are offered by National Savings & Investments and because they are backed by the Government and are a safe way of saving. They provide tax-free interest to children under 16 and you can invest between £25 and £3,000 per issue, of which there are several a year. You can invest online or via the Post Office.

Pros

• Tax free
• Controlled for the child until they reach 16
• Secure savings vehicle as backed by Government

Cons

• A limit on the amount that can be invested.
• Interest rate may not keep pace with inflation – so reducing the real value of your investment
• Child takes control at age 16, despite the fact they can be set up to be held until the child is age 21

Index-linked Savings Certificates (NS&I) – Although these investments were not specifically designed with children in mind they are, nonetheless, a useful investment vehicle, particularly as the value of the investment is guaranteed to keep up with inflation and returns are tax free. Usually you can invest from £100 to £15,000 for three or five years in Index-linked Savings Certificates but they have been pulled and are closed to new business. Children under seven need someone else to purchase the certificates on their behalf. Unfortunately Index-linked Savings Certificates are not available at present

Pros

• Tax free
• Controlled for the child until they reach 16
• Secure investment as backed by Government
• Will guarantee to provide a return in excess of inflation.

Cons

• A limit on the amount that can be invested
• Regularly pulled from the market due to oversubscription
• Child takes control at age 16

Premium Bonds (NS&I) – Parents, grandparents and great-grandparents can purchase Premium Bonds for a child, but a parent or guardian must hold the bond on the child's behalf until they reach 16. Essentially premium bonds are a monthly lottery where each bond is entered into the draw – with the chance of winning tax-free cash prizes. The plus side is that the original investment amount can be withdrawn at any time but there are downsides - See our previous post Money tip #57 – Are premium bonds worth it? The good, the bad and the ugly side of the nation’s favourite investment

Pros

• Easy to understand
• Winnings are Tax free
• Child can not control the investment until they are 16
• Secure - as backed by Government
• Potential (albeit almost non-existent) to make your child a millionaire

Cons

• Interest is not paid on this investment  - child receives winnings instead
• Almost non-existent chance of  hitting the jackpot
• Child takes control at age 16
• Inflation likely to erode the value of your investment

Unit Trust , OEICS and Investment Trusts - These are collective investments which give access to a huge range of investments from equities through to bonds. Again, they were not designed with children in mind but as children have their own tax allowances, the same as adults, they are useful particularly for more sophisticated investors. These types of investments are subject to capital gains tax as well as income tax – so it is possible to use your child’s annual income tax allowance and capital gains tax allowance) if you place them under a bare trust for their benefit. An explanation of a Bare Trust is given below

Pros

• Can be tax efficient if set up under trust as they allow the use of children’s tax allowances
• Give access to a wide range of investments such as equities
• A trust can restrict a child’s access until they are adults

Cons

• Potentially higher risk – but depends on the underlying investment fund
• Requires investment knowledge
• More difficult to set up

Bare trusts

Because children are not allowed to hold investments, they are often wrapped in a trust. A bare trust enables an investment to be held by an adult on behalf of a child.

The parent, for example, who holds the investment under trust has no beneficial right to it and must exercise control for the benefit of the child. Consequently the income arising on the investment is taxed as part of the child’s taxable income and any capital gains as part of the child’s capital gains.

To set up a bare trust is straightforward - the investment just needs to be made in the adult's name and the existence of the trust is simply denoted by having the child’s initials in brackets.

Individual Savings Accounts (ISAs)

When a child reaches 16 years old they can open a tax-free cash ISA, as long as they are ordinarily resident in the UK. The minimum age for a stocks and shares ISA is 18. Cash ISAs are available from all banks and building societies.

However, if your child is under 16, there is nothing to stop you utilising your own personal ISA allowance  but earmark the investment for them (Children can not hold ISAs). The children obviously have no right to the investment, and parents have no obligation to pass it on– which may not be a bad thing if little Johnny turns into the teenage delinquent from hell. This flexibility may be useful as it does not tie in the parents, unlike unit trusts in a bare trust.

Pros

• Tax efficient
• Can give access to a range of investment options (except in a cash-ISA)
• If parents (or grandparents etc) invest via ISAs the child has no right to them

Cons

• Stocks and Shares ISAs are potentially higher risk investments– but this depends on the underlying investment fund
• The interest rate may not keep pace with inflation on a cash ISA– so reducing the real value of your investment
• A limit on the amount that can be invested each tax year
• Requires investment knowledge if investing in funds (Stocks and Shares ISA)
• If investment is eventually gifted to the child, the gift may not fall within Inheritance Tax exemptions

Stakeholder pensions

It may sound strange but one option is to take out a stakeholder pension for your children. It is possible to invest up to £3,600 a year gross into a Stakeholder pension on behalf of a child (See my post Money tip #67 – Make pension contributions on behalf of your spouse and children and get tax relief even though they don’t pay tax!).

As the contributions attract tax relief at the basic rate, an investment of £3,600 would cost only £2,880. But while a Stakeholder pensions can be a useful way of boosting a child’s pension the downside is that the child cannot touch the money until he or she is 55.

Pros

• Tax efficient
• Contributions receive tax relief
• Child does not have access to funds

Cons

• Child does not have access to funds until they are 55
• Can only invest £3,600 gross per tax year
• Potentially higher risk investments– but this depends on the underlying investment fund. It is possible to invest purely in cash funds.
• Requires investment knowledge if investing in funds

Inheritance Tax

While I’ve mentioned the potential tax (income and capital gains) which the various options may be subject to, another tax to bear in mind is Inheritance Tax (which is payable on certain types of gift). However, if you give money to your children or grandchildren Inheritance Tax exemptions may mean that tax does not have to be paid on it. But if an exemption does not apply and you die within seven years of giving the money there might be some Inheritance Tax to pay depending on the size of the gift.