Why it pays to invest in your kids

Growing up is expensive. Whether your child decides to head off to university at 18, travel the world or take their first step onto the property ladder, it's all going to need a significant cash injection.

"Some of the costs are horrific," says Andy Brown, sales and marketing director at The Children's Mutual. With two children of his own, aged 19 and 21, he is fully aware of the bills that can roll in once they grow up. "We saved for them as they grew up but it's still staggering how expensive it is. My daughter went to university and we were looking at between £12,000 and £20,000 a year to cover the costs."
And it's set to get tougher. Government plans to raise university tuition fees – possibly to £9,000 a year – coupled with the scrapping of the child trust fund and child benefit for higher-rate taxpayers will pile on the pressure. 

The benefits of investing for your children

A bit of forward planning can make a significant difference. "With a time frame of around 18 years, it's one of the best opportunities anyone gets to save and take advantage of compound growth," says Jane Sydenham, investment director at Rathbones.

For example, assuming an annual growth rate of 6%, £100 a month over an 18-year period could be worth as much as £38,735.32. Get 7% annual growth and the final pot increases to £43,072.10.

As well as giving the child a financial head start with some of the inevitable costs of growing up, investing can also teach them about money and investment principles. "The earlier you can educate children about the value and importance of money the better," says Sarah Lord, managing director of Killik Chartered Financial Planning.

"I'm a great believer that the way you're brought up around money will influence the way you handle it when you grow up, so look for something that will engage them."
This doesn't have to be the entire investment strategy you intend to put together for your child and could be something simple like a savings account, where the child can learn about interest and get used to depositing money, or a more complex arrangement such as an online share dealing service, where the concept of shares can be explained to them when they're older.

It can also benefit you, especially from an inheritance tax perspective. Most gifts you make to a child will take seven years to leave your estate for inheritance tax purposes but by using the IHT exemptions you can speed this process up. Each year you can make a gift of up to £3,000, or as many gifts as you like of up to £250, to different people and these will fall immediately outside your estate.

Additionally, you could take advantage of the regular gifts out of normal expenditure exemption. Ben Yearsley, investment manager at Hargreaves Lansdown, explains: "As long as it's taxed income and giving it doesn't affect your normal lifestyle then it will be outside your estate immediately. It doesn't have to be a monthly gift either; Christmas or birthday presents also count as regular gifts. Just make sure you document it properly in case the taxman needs evidence."

Where to invest

Given the timescales involved, you can afford to be adventurous when it comes to selecting where to invest. Andy Parsons, advice team manager at The Share Centre, says that although some people like the security of cash, over an 18-year period it'll never keep pace. He recommends taking more risk by going for something offering the potential for higher returns, such as emerging markets, either as equities or bonds.

As well as emerging markets, other long-term, higher-risk investments that receive the thumbs up include Asia and infrastructure.

Although you might have the time frame to be a bit more gung-ho about your investment choices, you don't necessarily have to take this approach.

Tim Cockerill, head of funds research at Ashcourt Rowan, says a good broad spread of investments is sensible. "You can take more risk as you have more time but look to invest in a well-diversified portfolio including the UK, Europe and the US, as well as more exciting sectors such as the emerging markets and Asia. This will give as much opportunity for capital growth as possible," he explains.  

Investment vehicles

There are plenty of investment vehicles specifically for children, with some firms exploiting the nature of your investment with branded products. "Don't have your head turned by a teddy bear,' says Sydenham. "Always look beyond the gimmicks to performance."
Even though children can use their own tax allowances, investing tax-efficiently anyway is a good idea. You never know if they'll exceed their allowances in the future so sheltering their money from the taxman whenever possible is worth considering.

For some children, the child trust fund is an option. Although no new ones will be issued after the end of this year, every child born since September 2002 has qualified for one and, according to The Children's Mutual, that's around six million kids.

For these existing schemes, although government contributions have dried up, it'll still be possible to make contributions of up to £1,200 a year. Brown says: "It's a useful tax break, especially as it's exempt from the £100 income rule."

Anyone who missed out will soon have the government's replacement for the child trust fund, the Junior ISA, for their child's tax-free savings and investments. Although the final details are yet to be confirmed, it's unlikely to be available until autumn 2011, and will likely be very similar to the child trust fund. Returns will be tax-free, annual contributions capped and the money locked away until the child reaches 18.

Additionally, parents will be able to choose whether to invest in cash or stocks and shares. "We don't yet know the exact amounts but I would expect them to be in the region of £1,500 to £2,000 a year," says Hannah Edwards, head of new clients at BRI Asset Management.

"It's a logical step to have a successor to the child trust fund, especially where parents have two children, one qualifying for the child trust fund and the second born after the end of December 2010."

National Savings & Investments offers tax-efficient Children's Bonus Bonds, allowing you to invest up to £3,000 per issue with returns – a fixed interest rate plus a bonus after five years – tax-free.

The current issue (34) pays 2.5% per year, including the bonus rate, turning £3,000 into £3,394.22 after five years. "Issues are released regularly so you could invest quite a lot in these and structure them to mature during university for example," says Lord.
Another tax-efficient option that can be used for children is the friendly society tax-exempt savings scheme. This allows you to save up to £270 a year, or £25 a month, and providing you leave it for at least 10 years will be tax-free.

You can only have one plan per person but Brown says if you have plans in your name, your partner's and the child's, you could stagger maturity to help towards each year's university costs.

But while they're a potential tax break, Yearsley recommends caution when picking one. "On some schemes the charges are high and you'll end up in a with-profits fund. Personally, I wouldn't bother unless you really want the tax break or can use it to help educate the child about finances," he says.

For the ultimate in tax-efficiency, a stakeholder pension is an option. Contributions attract tax relief at 20%, so if you pay in the maximum £2,880 a year this will be topped up to £3,600.

"A stakeholder pension is the most tax-efficient way for parents to save for their children's future, although with the minimum retirement age 55 you do then run into the dilemma of whether you want them to have to wait so long for the money," says Sydenham.

The other beauty of a stakeholder pension is the length of time contributions have to grow. According to figures from Legal & General, if you invested £100 a month into such a scheme for a newborn baby until they reached 18, this would be worth £98,000 in today's money by the time they reached age 55, assuming inflation of 2.5% and growth of 7% a year.

Put in the maximum monthly contribution of £240 and the future pension pot could be as much as £234,000, enough to get them an annuity of more than £500 a month. 

Parsons has opened a stakeholder pension for his 11-year-old son. "We've invested the pension contributions in emerging market funds so, hopefully, by the time he retires it should be worth a decent amount," he says.

You don't have to go for a tax-efficient product either. "You could place any investment in a bare trust in the child's name to take advantage of their tax allowances," says Edwards, adding that parents need to be mindful that if any money they gift generates more than £100 of interest or income a year it'll be taxed as theirs. 

Control the investment

You might also want to consider when the child will get access to the investment. Some products such as National Savings & Investments Children's Bonus Bonds and friendly society savings schemes automatically become the child's at age 16, while they'll have access to anything held in a bare trust when they reach 18.

To avoid a financial blowout, more complex trusts can be used. For example, a discretionary trust will give you a say over when money is dished out and even allow you to change the beneficiaries if required.

But, although you get more control of the money, putting a trust in place is expensive. Cockerill recently explored using a trust for his own children's investments but was put off by the cost.

"They're not really worth doing for smaller amounts," he says. "You have to factor in the cost of solicitors, annual reports and accounts, which can run into hundreds of pounds."

Readymade trusts are available from some of the life companies. These cut the costs of running a trust considerably but the investment choice is more limited. Cockerill explains: "These trusts are wrapped around the life company funds, which isn't ideal."

The easiest option may be keeping the investment in your own name. Ian MacArthur, director of Sterling Financial Services, recommends doing this for larger amounts. "Children mature financially at different ages but giving them control of their education fund from age 18 may prove disastrous," he says. "This strategy can still be tax-efficient, especially if you have unused ISA allowances."

Even if you've already maxed out your ISA, other tax-efficient options are available. Maximum investment plans are 10-year plans and providing you allow them to run the full term, there's no further tax to pay. "The plans are taxed internally at between 15% and 20%, depending on the provider. This makes them a good option for a higher-rate taxpayer," says Paul Garwood, head of financial planning at Smith & Williamson.

Not everyone is a fan though. Lord says she would sooner recommend something cleaner, such as investing directly into funds, even though it might not be as tax-efficient.

Zero-dividend preference shares also offer tax breaks. Their finite lives mean they can be structured to provide a regular stream of capital, perhaps for university or school fees, and as they don't pay income, returns can often be sheltered within your £10,100 annual capital gains tax allowance.

Cockerill adds: "These have been very popular in the past for school fees and it might still be worth watching this sector. However, there aren't many around at the moment and returns aren't very enticing."

But whatever your strategy, you should review it regularly. Although higher-risk investments are prone to more volatility it's still prudent to check they're performing as expected every six months or so.

This article was originally published in Money Observer - Moneywise's sister publication - in December 2010