Money tip #80 – How to save and invest for your child’s future (part 2)

Part two of our guide on investing and saving for children.

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 The plus side is that the original investment amount can be withdrawn at any time but there are downsides - See our previous post Money tip #57 – Are premium bonds worth it?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 (currently £6,475) and capital gains tax allowance (£10,100) 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. Currently the maximum investment for a cash ISA is £5,100 each tax year. 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  (see my post Money tip #22 – Use your annual 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 a cash-ISA)
• If parents (or grandparents etc) invest via ISAs child has no right to them

Cons

• Stocks and Shares ISAs are potentially higher risk investments– but this depends on the underlying investment fund
• 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 we’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 you die within seven years of giving the money there might be some Inheritance Tax to pay. However, we will cover all this in a future post.