Building blocks for a brighter future

It’s never too early to start a savings account for a child. With Christmas upon us, parents and grandparents have an ideal excuse to begin building a nest egg that will give their child or grandchild a financial kick-start in life.What finer present could there be?

But simply stashing cash in the nearest deposit account may not be the best option. In fact if you don’t ensure you save in the right way, you could end up costing children a packet.

For starters there’s tax. Children don’t escape tax; they are treated as though they’re adults. With an annual allowance of £6,475, they are unlikely to pay tax on their savings unless they earn more interest than that, but if you’re planning to save for kids for some years to come, then you should be aware of the implications.

Next is the fact that, over the long term, putting cash into investments – such as shares, funds and bonds – is likely to give a better return than in a standard savings account. If you’re starting saving now for a toddler, for instance, you could be topping up their account for 18 years or so, which means looking at long-term opportunities.

Looking even further ahead, you could even consider saving into a pension for a child now. While they may not thank you immediately, over the long-term you could be doing them a huge favour. When you’re giving a fund 50 years or so to grow, the chances of it producing a decent return are much higher.

Sensible savings planning would probably involve a mixture of several things: a savings account, an investment fund, and even a pension fund. Each could be aimed at different solutions, whether it’s to give a child some rainy day money they can draw on when they want to buy things, or to build up reserves to help with university costs or to buy them their first car.

“Growing up with a savings account means children can see for themselves how small sums can grow and encourage them to manage their money responsibly rather than risk running into debt as soon as they start earning,” says Andrew Hagger, money analyst at personal finance website Moneynet.co.uk.

With interest rates at all-time lows, it’s essential to find an account paying adecent rate. Hagger looked at the best options currently available. “If you are going to look at opening a savings account for your child, I’d recommend the Halifax children's regular saver, which pays 6 per cent fixed for the first year,” he says.

With such a high rate, there are strict conditions savers must meet, which could rule the account out for many. For starters you must pay in between £10 and £100 every month which, unless you are prepared to make the commitment to save regularly for your child, will make it a no-no as the interest rate slumps to 1.05 per cent if you miss a monthly payment.

“Another good children’s regular saver comes from Principality Building Society,” says Hagger. It pays 4.5 per cent, which is less than Halifax, but the commitment is smaller. You must pay in-between £10 and £150 per month. “If you are looking to save a lump sum over a longer period, take a look at the Clydesdale Bank Child savings bond which pays 4.25 per cent fixed for five years,” says Hagger. “It’s held in the adult’s name but you cannot add to the balance or make withdrawals during the five-year term.”

For instant access and no penalties, he recommends the Little Rock Instant Access account from Northern Rock which pays 3 per cent and can be opened with only a pound. Bear in mind that savings institutions offer new deals all the time, so it’s worth keeping your eyes on the financial pages to see what else is out there.

Another warning: some children’s accounts offer great rates to begin with, but then gradually reduce them, so your kid’s savings can end up earning a paltry rate of interest if you’re not diligent.

Children born since 2002 and until the end of December 2010 have had a special tax-free savings account known as a Child Trust Fund opened for them, with a bonus start cash gift from the Government. Until August this year all accounts were opened with £250 from the Government, but one of the coalition’s first moves on coming into power earlier this year was to slash the payout to only £50 and scrap it altogether for children born after the beginning of 2011.

The coalition has subsequently announced that it will introduce new tax-free accounts aimed at kids to be known as junior individual savings accounts next year. These are expected to be similar to the existing ISAs that can be opened by adults, but they will not benefit from any government contribution. Details of how they work and what limits there are to the accounts are also awaited.

Putting children’s savings into a tax-free account makes good sense. So parents with children who have an existing Child Trust Fund should look to put saving in them to allow the money to grow with no worries about tax being demanded. When the new junior ISAs are launched they should also be attractive, but we’ll have to wait and see whether they have any restrictions.

Child Trust Funds have proved popular as parents and grandparents can easily add cash to them and they could be either simple deposit savings accounts or investment accounts, investing in stock-market related opportunities. The latter have proved particularly popular, especially bearing in mind the length of time that the accounts are likely to be in force and the restriction that a child can’t get access to the cash until they reach the age of 18.

“For children born between 1 September 2002 and 2 January 2011, parents, family or friends can still save a maximum of £1,200 each year tax free into Child Trust Funds,” points out Scott Gallacher, of the independent financial advisers Rowley Turton. “They are generally low-cost, tax-free saving vehicles with the only real downside being a restricted choice of schemes and the fact that the child gets the money at age 18.”

Most major high street banks and building societies offered Child Trust Funds and if your child qualified for one you can find out details of all the firms that offer them at the government website www.childtrustfund.gov.uk

Why is a tax-free account important? “Children have their own personal income tax and capital gains tax allowances and are able to hold their own bank accounts,” points out Adrian Lowcock, senior investment adviser at Bestinvest. “However, the existing process for investing on behalf of a child is unnecessarily complex and lacks transparency.”

If your child hasn’t been eligible for a Child Trust Fund, then there are two routes you can take to reduce tax problems, according to Lowcock. “First you can create a designated account where an investment is held in an adult’s name, usually a parent, with the designation made out in the child’s initials. The existence of the investment and its purpose needs to be clearly declared to HM Revenue &Customs and marked up in wills. “Alternatively, you can formalise the designated account by creating what is known as a bare trust. The benefit of this isthat HMRC recognises this, while the former method comes down to its discretion,” he says.

However, the drawback with bare trusts is the red tape. They require more paperwork to be completed and are not as easy to set up, which means parents need to seek specialist help to ensure they are doing it right and not falling foul of tax rules.

On top of that there’s a complication if a child earns interest of £100 in a financial year on cash that has been put into an account for them by a parent. Any income over £100 which is earned on the child’s account will be liable to the parent’s marginal rate of income tax and not the child’s. The rule was introduced to deter parents from putting lots of money in a child’s name to avoid paying tax on the proceeds.

“This tax trap can be avoided if the gift of capital comes from the grandparents, or the child themselves are able to put in their own money from earnings, such as a paper-round, or other part-time job,” says Philip Pearson, independent financial adviser with Southampton-based P&P Invest. Another option for parents to avoid this problem is to use a pension, says Lowcock. “[Up to] £2,880 can be invested into a stakeholder pension for a child and it will be grossed up to £3,600. Getting a head start on pension contributions is to be encouraged.”

Pearson suggests parents consider collective investment for their children’s savings. “If investing for the medium to longer term, then an alternative to a deposit account needs to be found in order to achieve a return greater than the effects of inflation over time,” he says. In collective funds such as unit trusts or OEICs, monthly saving schemes are available from as a little as £20. “Parents can save on behalf of the child by designating the account,” says Pearson. “This enables them to control the plan until the child reaches age 18, when they become legally entitled to take ownership.”

Growth within unit trusts and OIECs is free of tax within the fund. It allows tax-free returns to roll up over many years and any profit can be offset against the child’s capital gains tax allowance, which is currently £10,100 each financial year. “This approach therefore provides great scope for building tax free returns over the long term,” says Pearson.

He suggests M&G’s range of funds. “Each are available from a minimum saving commitment of only £20. I favour the Global Basics Fund which should provide a broad based international equity portfolio, aimed at achieving growth well above inflation over the long term.”

A similar option is to consider investment trust savings schemes which are available from as little as a £50 lump sum or £25 a month investment. “Investing in an investment company or children’s saving scheme could make gaining a degree or buying a new house amore affordable goal,” says Ian Overgage, acting communications director of the Association of Investment Companies. “The long term benefits of investment companies can make them ideal for this kind of investment and there are a diverse range of sectors and risk profiles to meet investors’ needs.”

Of course, when you consider stockmarket-based investment, such as unit trusts, investment trusts and OEICs, there are risks. If the market crashes then the money in the fund will shrink. If parents are unhappy with the risk then it can be an idea to put some savings into a hopefully more secure savings accounts, where returns should be steady but low, and just top up some cash into an investment in the expectation of achieving better returns.

Following this strategy should ensure that if there is a market crash, a child will still have the money stashed into the deposit account. If markets climb, then the child will profit from the growth.

Jason Witcombe, a chartered financial planner with Evolve says parents canhelp their children by ensuring their finances are tax-efficient. “Parents should have a coherent strategy across pensions, ISAs, mortgage repayments and other investments and retain control over when and how much money to pass to their children, perhaps to cover university costs or to put towards their deposit on a first home,” he advises.

Brian Tabor, a chartered financial planner and director of Care Matters mentions Friendly Society Savings Plans. “Modest amounts can be invested – from just £7.50 a month and the funds may grow more than in a deposit account over the longer term,” he says. “Also the funds have the same tax privileges as ISA.”

However there are potential disadvantages, points out Tabor. “You can only invest up to £100 a month, there are a limited choice of funds, and the charges may affect returns meaning the funds may not perform well.”

To discover more about saving for your children, click here.