Build a nest egg for your child with a CTF

It's expensive bringing up a child, but as they approach adulthood they will quickly start facing financial challenges themselves. At 18, they're faced with financial pressures that could include university fees, their first home or even a trip round the world. To give them a pot of money to make these decisions a little easier - and to encourage them to develop a savings habit - the Government introduced the child trust fund (CTF) for all children born on or after 1 September 2002.

This is a long-term savings and investment account that they can only withdraw money from once they reach 18. To get them started, every child who qualifies will automatically receive a voucher to open a CTF once their application for child benefit has been processed. This voucher entitles them to £250 to open their account, with children from lower-income families (annual income no more than £14,495) receiving £500.

In addition to this initial contribution, the Government will give them a further contribution when they reach their seventh birthday. This will be a further £250 - or £500 for lower-income families - and will be paid straight into their account. The Government is also consulting on making a further contribution when the child goes to secondary school.

It's tax-free!

The other benefit of the CTF is that it's tax-free, so there is no income tax deducted from interest or dividends, nor any capital gains tax liability when money is withdrawn. On top of this, money invested into the CTF isn't counted as the parents' from a tax perspective. In other investments and savings accounts, if each of the parent's contribution generates more than £100 a year in interest or income, it is taxed as theirs rather than the child's. So it's a good place for parents to place their money if they are likely to breach the £100 rule on other investments.

While the tax breaks will make their money grow faster, if a child wants to have a sizeable pot when they reach 18, they'll have to look to friends and family to top up their CTF. On top of the money provided by the Government, anyone can pay into the child's account, whenever they like, up to a total annual ­contribution of £1,200.

This makes a significant difference to the size of the investment. For example, assuming the child only received the two £250 contributions from the Government, at 18, this would be worth £821 if it grew at 5% a year. If it grew at 7% it would be worth £1,090, and £1,440 if it grew at 9%. Pay in £50 a month and it would be worth £15,700 at 5%, £19,100 at 7% and £23,400 at 9%. If you topped it up with the maximum monthly contribution of £100, the final values would shoot up to £30,579 at 5%, £37,110 at 7% and £45,360 at 9%.

The rules on when you can top up a CTF are fairly relaxed. While you can set up a regular monthly or annual standing order to pay into the account, ad hoc contributions are also possible, with minimum single contributions ranging from just £1 to £500, depending the account.

Losing control when they hit 18

There are disadvantages to topping up a CTF though. As your child is automatically entitled to the money at 18, you will have no say over how they spend the money. But, although there's a fear that they'll fritter it on a fast car or a global drinking binge, research by child savings specialists The Children's Mutual found that when given the proceeds of a savings scheme children appreciate its value and spend it wisely.

And, if they don't need the money at 18, they have the option to roll their CTF into an ISA and continue to enjoy tax-free savings and investments.

Types of CTF

There are three types of CTF to choose from: the stakeholder account; a shares account and a savings account.

The stakeholder account requires the money to be invested in the stockmarket across a number of companies rather than just one, so there is sufficient diversification and reduced risk. Subsequently, many of the stakeholder CTFs invest in tracker funds, which mirror the performance of a stockmarket index such as the FTSE 100 or the FTSE All Share. These accounts also feature 'lifestyling', whereby once the child turns 13, the fund is switched into lower-risk investments, like cash, to protect the fund from a stockmarket crash.

There are rules on contributions as well, with the Government requiring stakeholder CTFs to accept a minimum of £10, although some providers will accept less.

Charges must also be within the Government's parameters - below 1.5% a year. Because this ceiling is in place, many of the providers charge the full 1.5%, but lower charges are on offer.

It's also possible to invest in an ethical account, if you would like your child to avoid sectors such as arms or alcohol, or you'd like them to invest in environmentally aware companies. There are also Sharia accounts, based on Islamic values, which do not invest in alcohol, tobacco or gambling.

Stakeholders are the Government's default option and any CTF provider must offer a stakeholder option. And, if a parent doesn't invest their child's voucher within a year, a stakeholder account will beautomatically opened on their behalf.

As well as the stakeholder account, providers can offer non-stakeholder CTFs that invest in shares. This might be because the charges are higher or because the underlying investment or minimum contributions doesn't conform to Government rules.

This doesn't necessarily mean they should be ignored. Bowes recommends the Children's Mutual CTF, which has access to a range of funds including Invesco Perpetual's Income fund, and the F&C CTF, which gives access to a range of investment trusts.

There are also a few stockbroker CTFs available, offering much broader investment choice. With these you pay an annual charge plus dealing charges when you buy and sell shares. "I wouldn't recommend these for smaller CTFs because of the charges, but once you have a good sum of money built up they're great for really broad exposure," says Bowes.

Finally, the savings account CTF is available for anyone who doesn't want to invest their child's money in shares. As the name suggests, these are deposit-account based. There isn't a lot of choice, as only 14 banks and building societies offer them, but rates can be attractive. For instance, at the time of writing the best rate was 7.15% from Britannia (including a two-year bonus).

If you do plump for a savings account CTF, keep an eye on rates as they are variable.Moneywise reviews the accounts on offer on a daily basis in our Savings Round-Up.

Remember, bonuses are common, and rates will drop at the end of the bonus period, so be prepared to move to a better deal. But while this option may appear the safest as your child's investment cannot fall in value, performance suggests it might not be the best choice for an 18-year period.

According to figures from Lipper, £250 invested 18 years ago in the average unit trust would now be worth £1,202.12. The same amount invested in the average savings account would only be worth £571.57. And if you'd been lucky enough to have picked the best performers, you'd have netted £4,734.05 from the funds and £726.49 from the savings accounts.

Whichever CTF you select, it's possible to move between them, either with the same company or to a different one, without penalty. This can be useful if stockmarket performance isn't good or if you want to move it into less risky assets if you intend to cash it in.