Tax-free investing for kids

9 September 2013

When parents decide to squirrel away cash for their children's future, they want that money to work as hard as it can to produce the strongest returns possible.

A sensible way to maximise the gains, whether the investment is in a cash savings account or riskier stocks and shares, is to shelter them from tax - and not just in tax-efficient savings plans. Ordinary deposit accounts can be tax-free, too.

Savings accounts

Most children are non-taxpayers and, even if they do have to pay, they benefit from an annual income tax allowance like anyone else, which means they can earn £9,440 in the current tax year before they pay tax. So the first step is to make sure they don't pay tax unnecessarily on their savings interest.

The safest home for their money is a bank or building society savings account, where the cash is protected by the Financial Services Compensation Scheme up to a limit of £85,000 for accounts with one provider, so parents need not worry that it will vanish if the organisation goes bust. Normally, interest on savings accounts, even children's accounts, has 20% tax deducted before you receive it. However, you can avoid this for your children by asking for the interest to be paid gross. You need to do this by completing a form R85 from your chosen bank or building society.

Choosing a children's account should be as easy as ABC: you just look for the highest interest rate. But, in reality, you will find providers may attempt to distract you with marketing literature and the lure of gifts and financial enticements such as bonuses that quickly disappear.

Anna Bowes, director of savings comparison service, warns parents to be wary. She says: "Many kids accounts come with gifts. Generally, these are money boxes, but you can also get soft toys, wall charts, stickers and even a ticket to the zoo. It's all very well opening an account with a small amount in order to get a gift, but once the amount becomes more substantial, it's the interest that should be driving the choice of account rather than the gift. Interestingly, very few of the accounts on our children's best buy tables offer a gift as an incentive - so buyer beware."

Another important snag to watch out for is a special rule that applies if the savings are a gift from parents. Bowes says: "This is the '£100 rule', which means that if any annual interest goes over £100, the whole interest amount, including the first £100 counts against a parent's tax allowance instead. This does not apply to grandparents or other friends and relatives who gift the money."

When it comes to best buys, topping the list for regular savings is Halifax's one-year Kid's Regular Saver at 6% gross for a minimum £10 a month (maximum £1,200 a year), followed by a similar account from West Bromwich Building Society at 4.6% gross.

You need to watch out for individual account quirks, such as Skipton's Leap Account Issue 2, easy-access account which, at 2.75%, includes a 0.5% bonus that ends after 12 months (so check that it is still competitive after the period or switch the money elsewhere). Fixed-rate deals also have tougher rules, such as loss of interest if you cash in early.

For the best deals at the time of writing, see our savings table.

Beyond standard accounts, the big change to children's accounts has been what Bowes describes as the "Child Trust Fund (CTF) and Junior Isa (Jisa) debacle". CTFs were savings accounts available for children born between 1 September 2002 and 2 January 2011, which parents could use to deposit free government vouchers worth £250 (lower earning families received more). These could be topped up to £3,720 a year until your child is 18 (it must be locked away until then) and the interest is earned tax-free.

However, CTFs are no longer available to newborns - they were replaced by Jisas in 2011, although if your child still has one you can keep paying in until it matures. Inevitably though, these CTFs are generally paying less competitive rates. The best is Yorkshire Building Society's, at 3% but that includes a 0.7% bonus for the first 12 months.

Bowes adds: "Worse still, there is little option to shop around as very few accept transfers in, and currently CTFs cannot be switched into Jisas. However, this may soon change if proposals outlined by the government come into force."

Junior Isas

Jisas differ in that there are no free vouchers for the kids who have one. But you can save the same amount as in a CTF - up to £3,720 each tax year - and they also can't get at the money until age 18. At that point, if they do not cash it in, it will be rolled over into an adult Isa.

The best Jisas are paying 4% and 3.25% at the moment, although Halifax is paying 6% if the child's parent or guardian also holds a Halifax Cash Isa (3% if not).

Another option is for parents to open their own Isas and simply earmark that cash for their children. Patrick Connolly, IFA for investment adviser Chase de Vere says: "The advantage is parents can have control of the money and access if they need it as it's not locked up till their child reaches 18, plus the annual cash limits are higher than for Jisas, currently £5,760."

Stockmarket Jisas

A potential 18-year investment horizon makes equity investment a suitable option for parents who are prepared to see their children's savings ride the ups and downs of the stockmarket. Connolly says: "With cash, in real terms you lose money with inflation, although accounts are a good place for birthday and Christmas money."

For the longer term, he says that, rather than picking individual shares, parents should look at collective funds that pool investors' cash and then use it to invest in dozens of underlying shares. These funds can in turn be sheltered from income tax and capital gains tax in an Isa (which has an annual limit of £11,520, or £5,760 if you also have a cash Isa) or Jisa (annual limit of £3,720, for both cash and stocks and shares).

Connolly adds: "A good place to start is with a low-cost tracker fund that replicates the FTSE All Share Index. For those wanting to take more risk, there are funds such as JPM Emerging markets and M&G Global Basics."

Another tip is to drip-feed money into the stockmarket. He says: "If you invest a lump sum at the wrong time, you can lose heavily. By drip-feeding monthly, for example, the same investment will simply buy more units when the market drops."

Friendly society savings plans

You can also save an extra amount tax-free using a friendly society savings plan, which lets you save up to £25 a month for each child over periods from 10 to 25 years, with bonuses paid rather than interest.

Such plans, which are invested in with-profits funds, are often criticised for their high charges and inflexibility. However, they can provide a useful savings discipline and some providers offer extras to plan holders.

For example, Forester's Friendly Society gives useful perks to those who have been members for six months or more, such as being able to claim an annual £25 book voucher, as well as online discounts and the chance to claim a discretionary educational award to help towards education or training.

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