Investments for children

In addition, the longer your investment horizon, the more you can afford to invest in higher risk assets such as equities, property and corporate bonds. Whereas if you are investing over five years, you would normally be advised to save in lower risk assets, such as cash and fixed interest securities.

Regular saving in a collective investment fund such as an investment trust, unit trust or OEIC, means that when unit prices are low, you automatically purchase more units for your money than when unit prices are high. This means that when the stock market rises, you will have more units that are worth more.

In addition, over the long term, stock market investments tend to outperform cash and deposits, although there is no guarantee that this will happen.

Child trust funds

One of the best ways to build up a nest egg for a child is to save via a child trust fund (CTF), or stakeholder pension, as these vehicles all carry various tax advantages.

The parents of all babies born in the UK, on or after 1 September 2002, have been eligible to receive CTF vouchers, worth £250, (£500 for the poorest families), from the Government. Further vouchers for the same amount are sent to parents when their children reach age seven. In addition, family members and friends can add up to £1,200 a year to the fund, which is tax free.

But remember that vouchers must be invested within 12 months of receipt. Otherwise, they will be invested automatically on your behalf by HMRC in a stakeholder CTF.

It is up to you to decide which type of CTF you want to invest in from the following three types:

• Stakeholder accounts
• Cash savings accounts
• Share accounts.

For more information read Defaqto’s guide to CTFs.

Individual savings accounts (ISAs)

A good vehicle for regular saving is an ISA as although there are no tax breaks on entry, there are no tax liabilities on withdrawal.

In the tax year 2009-10, you can invest up to £7,200 in an ISA, of which up to £3,600 can be invested in cash. From 6 October 2009, the over 50s can invest up to £10,200, of which up to £5,100 can be in cash. From April 6 2010, these higher limits will apply to everyone.

It is possible to convert a cash ISA into an equity ISA but not vice versa. So if you are not sure where to invest, or are wary stock market volatility, you could invest in cash for the time being, and convert the money into an equity ISA at a later date.

A major advantage of investing via an ISA is that investment funds can often be purchased more cheaply within an ISA wrapper (providing you buy through an independent financial adviser, fund supermarket or a discount broker) than if you bought the same fund from the fund managers directly.

ISA savings are also highly accessible in that your child can access the savings at any time without penalty. The same cannot be said of pension savings which are locked away until the beneficiary reaches age 55 (from 2010).

National Savings & Investments

There are a number of tax free, fixed income investments available from NS&I which you may like to consider.

Children’s bonus bonds: Some National Savings are tax free. For instance, the NS&I children’s bonus bonds pay a fixed rate over five years and are tax free on maturity. Included in this rate, is a bonus which is contingent on you holding the bond for the full five years, otherwise you will not receive the full interest.

Premium bonds: Premium bonds have a number of prizes of differing amounts each month. You can invest from £100-£30,000 on behalf of a child under 16; providing you are the parent, guardian, grandparent, or great grandparent of the child.

Index linked savings certificates: You can invest from £100 up to £15,000 tax-free in each issue. The certificates pay a fixed rate of interest, plus the retail price index.

Other NS&I products you may wish to investigate include fixed interest savings certificates, capital bonds and income bonds. For details of NS&I’s products visit: www.nsandi.com/ifa

Stakeholder pensions

Few investments can beat contributing to a stakeholder pension for a child or grandchild as many young people cannot afford to make pension contributions until their 30s, even 40s, because of the need to service student debt and mortgages.

There are no tax implications for either the donor or the beneficiary and by investing for the first 18 years of your child’s life you will be giving them a flying start in the retirement savings stakes.

By the time your child reaches age 18, he or she can either start making contributions themselves, or, if this is not possible, simply leave the fund to roll up tax free until they reach age 55.

Many parents and grandparents are still unaware that, since the introduction of stakeholder pensions in April 2001, they can pay into a pension on behalf of a child/grandchild. In fact, anyone, including godparents and friends, can make stakeholder pension contributions on behalf of a child.

Tax rules on children’s stakeholder pensions

The rule is one stakeholder plan per child. So a group of relatives such as parents, grandparents, godparents and other relatives can contribute in total £2,808 (£3,600 gross) to a child’s stakeholder. The application form has to be signed by a legal guardian or parent, but the direct debit can come from any individual.

Contributions to all personal pensions are paid net of standard rate tax at 20%, even if the child is a non taxpayer, so that the maximum net contribution is effectively only £2,880.

HMRC adds an extra £720 in the form of 20% tax relief, making the total annual contribution £3,600. The £2,880 can be paid as a single lump sum or as regular monthly contributions.

But there is no higher rate tax relief, unless the child happens to be a higher rate taxpayer, which is highly unlikely. This means that even if you, as the parent, godparent or grandparent, are a higher rate taxpayer, you cannot claim higher rate tax relief because the tax relief is based on the child’s tax status, not yours.

How much will my investment grow?

For maximum effect, it is best to start contributions as early as possible. One insurer calculates that parents/grandparents, who invest £2,880 net a year for a child from birth until age 18, could create a pension fund of £327,000 by the time the child reaches 65. By contrast, a child who starts to save for a pension at age 30, making the same contributions, would build up a fund of just £127,000 by the same age.

A stakeholder pension is largely free of income tax and completely free of capital gains tax. There is a small deduction from dividends before they are paid which, since 1998 cannot be reclaimed by pension funds.

How to take the benefits from a stakeholder pension?

Under current rules, a pension can be taken at any time from age 55. Up to 25% of the fund can be withdrawn as tax free cash and the remainder used to purchase an annuity.

Alternatively, at retirement, it is possible to leave the rest of the fund invested in the stock market and take an income from the fund, when required. This is called taking ‘income drawdown’, or ‘unsecured pension’. This can be done until age 75, when most people will choose to purchase an annuity.

Friendly society bonds

Friendly society bonds are investment funds held within a life assurance wrapper, whose returns are tax free at maturity. They are often invested in with profit funds, whereby annual bonuses awarded over the life of the policy cannot be taken away, and the peaks and troughs of equity investment are supposed to be smoothed out through a bonus system.

With profits funds over the longer term should reflect the performance of the underlying investments. In certain market conditions penalties can be severe for encashment that is either early or not on a pre-designated anniversary.

Tax treatment of investments made by parents

Income deriving from investments made by parents of up to £100 is tax free but any such income in excess of £100 is taxable on the parents.

This is why it is a good idea to take advantage of tax free investments such as ISAs, CTFs, stakeholder pensions and those NS&I products which are tax free, when investing on behalf of a child.

However, income deriving from investments made by grandparents, is taxable as if it belonged to the child. This means that a child can offset this income against their own personal tax allowance of £6,475 and capital gains against their CGT tax allowance of £10,100 (tax year 2009-10).