Saving For Children: Trust funds that take toddlers to the market

As any parent will testify, it's expensive raising a child. The first 12 months alone cost more than £7,000, accord- ing to friendly society Liverpool Victoria, while years two to five are the most financially draining - averaging £9,993 per year.

As any parent will testify, it's expensive raising a child. The first 12 months alone cost more than £7,000, accord- ing to friendly society Liverpool Victoria, while years two to five are the most financially draining - averaging £9,993 per year.

But for families with children born on or after 1 September 2002, a little extra financial help is at hand in the form of the Government's child trust fund.

Due to launch this April, the scheme will give £250 to each qualifying child - rising to £500 for low-income families. If you are eligible, vouchers may have been sent to you already.

It's up to parents to decide where to invest this money, which will grow tax-free until the child's 18th birthday, while friends and family can add another £1,200 a year.

When looking at investment vehicles for a child trust fund, you have three basic choices: a deposit-based account, a "stakeholder" and a "non-stakeholder".

The deposit account offers no risk but modest growth compared with the stakeholder fund, which invests in equities before switching to safer bonds and cash once children reach their teens. In contrast, the non-stakeholder fund carries higher charges but aims to generate more growth through riskier stock market investments.

The scheme is aimed at encouraging long-term saving - but this poses a problem for families with children born before 1 September 2002. In the case of the Bird family, from Wallisdown in Bournemouth, only the youngest child - two-year-old Georgina - is eligible for the child trust fund. Her brothers - Leo, 3, and Robert, 5 - are not.

The children's parents, Liz and Matt Bird, have received the vouchers for Georgina and plan to invest the money in a non-stakeholder with-profits product from Liverpool Victoria. But at the same time they want to give all three of their kids the best possible start in life.

"We are now looking into setting up tax-free savings plans for the boys," says Matt, 32. "We would hope to save around £25 a month for each child so we can build up a nest egg for them all."

Such tax-free plans are run exclusively by friendly societies and are suitable for parents who want to save regularly over the long term. You typically invest a monthly sum, say £25, over a minimum of 10 years and cash it in - or reinvest - when the plan matures.

However, these plans can carry high charges and have an element of life insurance that eats into returns. Parents could look elsewhere.

"You should start saving as early as possible - and go on saving regularly," says Anna Bowes at independent financial adviser (IFA) Chase de Vere. "You should approach your children's investments in the same way you would your own - according to your attitude to risk."

But she advises parents to consider equities if they are investing over the long term - and picks out the Fidelity Wealthbuilder and Invesco Perpetual UK Equity Income funds.

If you opt to invest in a fund for your baby, you should set up a "bare trust" in their name, she adds. When your child reaches 18, all income and capital in the trust will pass to them and be taxed as their own. Remember that your child has an absolute right to the money; you can't change your mind and spend it.

Other savings options popular with parents include children's "bonus bonds" issued by National Savings & Investments (NS&I). These offer tax breaks and capital guarantees. However, the interest paid (with bond issue 17) has just fallen to 4 per cent - it had been at 4.45 per cent since August 2004.

If none of these options seems appropriate, you could simply opt for a high-paying savings account. Ms Bowes suggests a new instant access account from Coventry building society - returning a fixed 7.25 per cent in the first year on child benefit paid directly into it.

Even in the second year, with a reduced rate of 6.25 per cent, it's likely to offer better returns than other deals.

Remember when saving for children that they all have a personal income tax allowance. This means that as long as the money is their own or has been given by someone other than a parent, they can receive up to £4,745 tax-free in the current financial year - rising to £4,895 in the new tax year.

To ensure the interest paid on savings up to this sum isn't taxed, you will need to fill in an R85 form - available from all banks, building societies and tax offices.

Also beware that if the annual interest earned from your own contributions to your child's account tops £100 it will be taxed at 20 per cent basic rate and deducted from the account. You can get round this by asking grandparents, godparents and friends to contribute - all interest is then tax-free.