Give your child a head start in life

Hannah Ricci 10.04.07

According to industry research, one in four parents said they would have set up a savings account when their children were born if they had realised the cost of supporting their child through further education.

Tax

Before you start saving it's crucial to consider the tax implications. Children have an annual tax-free allowance like adults (£5,225 for the tax year 2006/07). But, unlike their parents, most children don't meet this allowance with earnings, so their savings should effectively be tax-free.

Ensure your child isn't paying tax on savings by filling in the HM Revenue and Customs form R85, which you can pick up from your bank. "Parents need to be aware however, that if their child earns more than £100 a year in interest, from money given by each parent, this will be taxed at their own tax rate," explains Andy Gadd, head of research at independent financial adviser, The Lighthouse Group. However, money given by friends and family won't be.

Where your money should go

You have time on your side, which means you can look at riskier investments that provide the potential for better returns. You also have the benefit of compound interest to assist your savings.

It's also worth looking beyond cash. Gadd says overcautious parents often miss out on getting the most out of their children's money. "It's well known that equities have outperformed all other asset classes over a 10-year period. The concept of pound-cost averaging also helps with regular investing for children," explains Gadd. Pound-cost averaging works on the basis of investing small amounts on a regular basis. When prices are high, your monthly contribution may buy fewer shares or fund units, when prices are low your investment buys more. As a result, you have the benefit of more units once prices start to rise.
Of course, you need to be comfortable with the risk of investing in equities and it's a good idea to build up a balanced portfolio and include more secure savings as well.

Collective investments

Unit trusts which pool together investors' money to invest in a range of stocks and shares are a popular way of investing for kids. However Francis Klonowski's favourite approach is investment trusts. "They are low-cost compared to the alternatives and they offer a great deal of flexibility," he says.

According to the Association of Investment Companies, investing £50 a month in the average investment company over the last 18 years would have resulted in a nice sum of £29,330 - a brilliant start to adult life. Saving £50 a month in cash however, would result in a markedly less exciting £17,460.

There are several investment trusts marketed specifically for children, but all of them can be used for this purpose. Often the only difference is lower minimum contribution levels.

Francis Klonowski advises looking at global investments for about the first 10 years, then becoming more UK focused as they near 18. He particularly likes the Alliance Trust (ATST), a global growth investment trust.

Following an initial investment in Alliance Trust, Klonowski advises looking at a UK fund such as the Temple Bar (TMPL) investment trust and then spreading to Europe through Fidelity European Values (FEV). "I also like Aberforth UK Small Companies (HIUKSC)" he adds.

If you do aim to hold more than one investment for your child it's worth looking into 'wrapper' accounts that allow you to hold all your investments in one place and switch in and out of funds cost-effectively. Alliance Trust offers an account called First Steps (a children's version of the Alliance Trust investment plan), while Henderson (HGI) offers an account called Itshenderson. It isn't a dedicated children's scheme, but there's no reason for it not to be used for this purpose.

Child trust fund

If your child qualifies for the child trust fund this is another way to get exposure to the stockmarket. Every child born after 31 August 2002 will receive a voucher for £250 (£500 for lower-income families) to be invested, with a further £250 or £500 at age seven. You can choose between one of three different types of CTF. The first is an ordinary savings account; the second is an investment fund linked to the stockmarket and the third option is the stakeholder CTF. Again, it is investment linked, but it automatically shifts funds into lower-risk investments such as cash before your child turns 18. If you don't actively invest your child's CTF within a year of receiving it, the government will invest it for you in a default stakeholder account.

Friends and family can top up the account - up to a maximum of £1,200 a year. Figures from The Share Centre show that contributing £25 a month from birth, assuming 2.3% inflation and 4.5% growth, could result in £7,002 at age 18. If you invest the CTF voucher more aggressively, you could receive returns of 7% and £9,082 in 18 years' time.

Shares

Investing directly in companies is another way to build a fund for your child. Junior Accounts allows parents to make regular contributions to invest in stocks and shares and manage the account in one of two ways. Parents can hold the account in their name and designate their child to become the owner after they reach 18, or the account can be opened in the child's name and held in a bare trust until they turn 18.

Flexible saving

The CTF or any investment held in a bare trust for your child will automatically become theirs when they turn 18 - so you'll have little control over how they spend it.

Children's Bonus Bonds from National Savings and Investments (nsandi.com) are a good way to achieve this and balance against the risk of the stockmarket. "These government-run bonds provide tax-free saving of a maximum of £3,000 over five year periods," explains Andy Gadd. "They offer a guaranteed rate, currently 4.6% AER and a bonus on the fifth anniversary. After five years, you can cash the bond in or leave it invested. Children can access their bond when they reach 16, but they also have the option to leave it invested tax-free for a further five years until they are 21."

Gadd also advises looking at tax-exempt savings plans, which are available from friendly societies. Tax-exempt savings plans are stockmarket-based investments that allow you to pay in up to £25 a month (£270 a year) for each child. As long as you leave them for at least 10 years, the return will be tax-free.