The good news is that small amounts can really add up if you save regularly from the child’s birth. A contribution of as little as £10 a month at an interest rate of 3 per cent could give a child nearly £3,000 by the time he or she reaches 18, while saving £300 a month could produce a whopping £85,800.
For those looking even longer term, 18 yearly payments of £2,800 into a children’s Self Invested Personal Pension (child SIPP) could make little Billie a millionaire by the time he turns 65.
How to save: tax and children
Most parents choose to save in their child’s name rather than their own for tax purposes. By saving in your child’s name, the interest earned is generally tax-free (up to certain limits) as children get the same tax-free allowance as adults.
So, whether you are saving into a Junior ISA (JISA), NS&I Premium Bonds or an ordinary savings account your child’s interest will remain tax-free up to the HMRC personal allowance limit, set at £10,000 for 2014/15.
The exception to this is the so-called ‘£100 rule’. This stipulates that any amount of interest exceeding £100 that results from a payment made by a parent to a child must be taxed at the parent’s tax rate.
This rule is applied to almost all children’s savings accounts except JISAs – which are totally tax free in the same way as adult ISAs.
Another advantage of JISAs is that the cash inside them is automatically transferred to an adult ISA when the child turns 18, meaning that any interest from this money remains tax-free.
By contrast, the same amount in a regular savings account would begin to incur tax on the interest when the child becomes an adult.
It is important to bear in mind that any account held in your child’s name becomes legally theirs to do with as they wish at age 18. And as we all remember, that is not always the best age to have a large lump sum to hand.
The alternative is to set up a discretionary trust for your child, but this route will incur hefty legal and administrative costs and so is best suited to those with significant property and/or funds to bequeath rather than the regular saver.
Investment products for children
Following is a list of popular savings and investment products for children.
Junior ISAs (JISAs)
JISAs were launched in November 2011 to replace the Child Trust Fund, and any child who was not eligible for a Child Trust Fund (see below) can have a JISA.
JISAs have an annual savings limit of £4,000 (from 1 July 2014), which can be held entirely in cash, stocks and shares or any mixture of the two.
Anyone can pay into the JISA although a parent or legal guardian must set it up and funds cannot be withdrawn until the child turns 18. As an added bonus, JISAs can be held concurrently with an adult ISA between the ages of 16 and 18, giving the child an boosted tax-free allowance for two years.
Only two JISAs may be held per child at any one time – one cash, one stocks and shares.
This differs from adult ISAs, where you can open one of each type per tax year.
Child Trust Funds (CTFs)
CTFs were launched in 2005 as a way to encourage parents to save for their children from birth. The UK government offered to pay £250 into the account when the child was born and £250 on the child’s seventh birthday as an incentive.
They have now been replaced by JISAs and the government stopped issuing vouchers in January 2011. Existing accounts will remain open and the savings limit has been raised from £1,200 to match JISAs.
At the moment, funds in CTFs cannot be transferred to JISAs, and children born between 1 September 2002 and 2 January 2011, who were eligible for CTFs, are not allowed to have a JISA. However, George Osborne has announced that transfers from CTFs to JISAs will be possible from April 2015.
Childrens’ savings accounts offer interest comparable to JISAs, but they allow instant access to the funds any time before the child turns 18, unlike JISAs which effectively lock the money away till that time.
They can be useful for teaching children financial housekeeping as the child is given access to the account at age seven and can pay in and out of the account as they grow.
However, regular accounts tend to have lower savings limits than JISAs with many providers slashing interest rates if deposits exceed a certain amount.
Cash saving notice accounts and fixed-rate bonds
As with adult savings accounts, cash savings notice accounts and fixed-rate bonds for children often offer better rates of interest than regular accounts.
Many also allow you to save more than a regular account or JISA does, making them a viable option for those who wish to put more away.
Carrying notice periods of between one and five years, they also serve as a middle ground between instant access and JISAs for those who need the option to use the funds earlier.
Child SIPPs allow parents to pay into a pension for their child from the moment they are born. Like adult pensions, child SIPPs are eligible for 20 per cent tax relief meaning that you only have to pay in £2,800 per year to receive £3,600 back.
As mentioned earlier, SIPPs are incredibly attractive if you are the kind of person who really enjoys planning ahead and you want to help your child enjoy their twilight years.
At an assumed interest rate of 5 per cent, 18 yearly payments of £2,800 would equal £1,053,405 by the time your child reaches 65. Like all pension plans however, they cannot be accessed until 55 at the earliest.
A trust is a legal arrangement where one or more ‘trustees’ are made legally responsible for holding assets for the ‘beneficiaries’ – in this case, your child or children.
The assets – such as land, money, buildings, shares or even antiques – are placed in trust for the beneficiaries and the trustees are responsible for managing the trust and carrying out your wishes as the ‘settlor’.
There are two types of trusts: bare trusts, which give the children an absolute right to access their money at the age of 18, and discretionary trusts, which allow trustees to decide when and how much to pay out. For more information, see HMRC’s website.
It is perfectly possible to save money into your own ISA for your children, if you are not using all of your allowance yourself. The advantages are that you will be able to control the money, even when the child turns 18, and you will have a bigger allowance to use (£15,000 from 1 July 2014).
The disadvantage is that although the money will receive the same tax breaks while it is in the ISA, there is no way to transfer the money to the child without it leaving the ISA wrapper and losing its tax-privileged status.
Also bear in mind that your child has no automatic legal right to the money and this could cause problems in the event of death or divorce.
Cash or stocks and shares?
More than two-thirds of the 300,000 Junior ISAs that had been opened by parents up to the end of the 2012/13 tax year were of the cash variety. Unlike with adult ISAs, it is possible to save 100 per cent of a child’s annual Junior ISA allowance in cash. However, this may or may not be the best decision.
Because interest rates are so low at the moment, it is difficult to find cash accounts that pay interest of more than inflation. This means that effectively, you could be losing money in real terms every year.
There is of course a risk that you will get back less than you started with, which is what puts many people off.
However, history suggests that the chance that the stock market will be lower than it is now at the end of 18 years is a very small one.
You can also take a mixed approach, investing some money in cash and some in stocks and shares.
Some financial experts argue that as the child approaches her 18th birthday, you should move the money from stocks and shares to cash so that it is ready to be used if necessary.
This also reduces the risk that a big stock market crash just before your child turns 18 will reduce the money she might need for her future.
Guide originally published: 23/4/13. Updated: 3/4/14.