Banking on what's best for your baby

It was one of those anguished letters new parents write when they have hit yet another seemingly insuperable problem over their new-born infant. "I have a two-month-old baby," wrote Phil Evans, an economist living in Hackney, east London. "She was given money for Christmas. What should I do with it that will offer a good return over the long run and is tax-efficient, please?"

Rosie was born to Mr Evans and his partner, Susan Clough, on 13 October, so in her short life she has already had two lots of presents including more than £350 in cash from smitten grandparents. Rosie's parents want to invest this and then top it up regularly, as birthdays and Christmases clock up.

The first port of call for such money is a savings account that banks and building societies specifically target at children. The ones listed below (see table) tend to pay more than an adult savings account, and interest is usually credited tax-free. The key is to be hard-headed and compare children's accounts with what is available elsewhere. Some offer poor value on the pretext that the child will receive a regular birthday card or a gift that could be bought cheaply in a shop.

A radical way of maximising the return on a child's savings is to use it to cut the parents' debt. Heather Scott, at Intelligent Finance, the HBOS internet bank, said: "The parents should use it to offset their own mortgage/personal loan or credit card. What better way? It's the best of both worlds isn't it? It's still in the nest-egg for Junior, but it's being used to reduce the burden that Junior has imposed on you."

The other big consideration is tax. Children are entitled to their own personal allowance, at present £4,615 a year, as it is for everyone, which is the amount they can earn before they are liable to start paying income tax. For most children this is the amount of dividends or interest they can get tax-free. Even on a savings account or high-yield bond fund paying 5 per cent, someone would have to hold nearly £100,000 before they had to pay tax on the income.

But it is different if the child's money comes from parents. Then tax kicks in on anything above £100 a year per parent. That is why it is worth making sure the money is in the child's name from the start, and deposits or investments are made by someone other than its parents, say, grandparents. If the income has been paid net of tax, the tax can be reclaimed on interest from a savings account, but not from dividends. To ensure interest is paid gross, parents should complete Inland Revenue form R85. Children also have the same limit on tax-free capital gains, £7,700 a year.

The other approach is to set up what is called a bare trust. This is legally binding, giving parents or other adults only administrative control as trustees. The assets can normally be transferred to the child on reaching 18, or later, if the trust deeds say so. But again, parents' gifts cannot escape tax in this way.

The other possibilities are Isas (individual savings accounts) and stakeholder pensions. But, until the child is 16 they cannot hold an Isa in their own name, so that would have to come out of an adult's £7,000-a-year allowance. And, although it is tax-friendly, the child could not touch the pension until he or she reached the age of 50, soon to rise to 55.

Jason Butler of Bloomsbury Financial Planning in London said: "You've got to work out your objectives. If it's just to put money away for about five years, cash is the only place. If you don't want the child to touch it until 21, you can do a lot worse than a big generalist investment trust, such as F&C or Alliance Trust."

As far as Rosie's nest-egg is concerned, Mr Evans and Ms Clough want to keep their options open. "We're taking a long-term view," said Ms Clough, a teacher at a secondary modern in nearby Stratford. "We have our own savings and we wanted something that would still be there for Rosie, in her own name, if she thinks about going to university. But we don't want to lock it away. We'd like to keep it flexible."

Ms Clough has gone a long way towards defining the sort of investment that would be right for Rosie. "For 15 or 20 years it's worth exploring equity-linked investments," said Philippa Gee of the independent financial adviser (IFA) Torquil Clark in Wolverhampton. "There is no guarantee of how well the money would do, but over that time it should give a better return than a bank or building society account. HSBC's FTSE All-share Index tracker has low costs and no gimmicks, and will reflect the performance of the stock market."

Alan Steel, an IFA in Linlithgow, East Lothian, said: "I would be inclined to look at the question simply and use something like an investment trust or an Oeic (open-ended investment company) which has a savings plan. You can take a long view and think about pound-cost averaging. By buying regularly you take advantage of the lows in the market, and whether we are at the bottom or not now we are definitely much lower than we were."

Mr Steel plumps for two Scottish investment trusts, one the long-established Alliance Trust, the other the Personal Assets Trust run and largely owned by the idiosyncratic but highly successful Ian Rushbrook. Another highly respected Scottish investment group which has developed a plan aimed at children is Baillie Gifford. Last November, it launched the Baillie Gifford Children's Savings Plan to provide a flexible, low-cost, user-friendly way to buy and hold shares in the range of six investment trusts it manages. Savings can be made from £30 a month or with a minimum lump sum investment of £250. There are no management charges or commission, beyond stamp duty and a £20 exit fee.

Robert O'Riordan, Baillie Gifford's investment trust liaison & development manager, said: "The plan is gimmick-free. It offers a straightforward route for investing on behalf of children, whether your own child, a godchild, grandchild, nephew or niece."

The most controversial area for children's investment is to put it in a friendly society bond. Because of a concession to these societies, the first £25 a month saved is tax-free. David White, chief executive of Tunbridge Wells Equitable Friendly Society, said: "Our mission is to encourage parents to factor saving for children into their financial planning as soon as Junior is born. The company is most well-known for two products, University Bond and Baby Bond, both long-term savings products, with tax incentives. We believe the ability to stop saving as and when could hinder long-term savings returns. Ease of access, for instance, into a deposit account, could be a temptation to dip into savings."

But Chartwell, the Bath-based IFA which has a succinct guide on investing for children, says of friendly societies: "Investors should not be tempted simply by the tax advantages. Many of them have had poor performance because of higher costs proportionate to their smaller premiums."

Chartwell's guide is available free via its website, www.chartwell-direct.co.uk/guides.cfm, or call 01225 446556.