In the dim light of bleak mid-January, many parents will be looking philosophically at the pile of broken plastic that was the kids' Christmas presents. Many may resolve to give something that will last longer and many will be looking at making an investment for their children's future.
The traditional approach has been to put money in a deposit-based savings acc ount. But, with future dem ands for money increasing, equity exposure has to be considered. The rules that apply to adults are just as relevant to children – get the basics right first and then develop the portfolio.
Creating a portfolio for children works on a rising scale of risk and commitment. Start with deposit-backed accounts and then move toward equity-backed investments.
The top 50 children's acc ounts offer an average interest rate of 5.99 per cent and are not dependent on bonus payments, as are most “adult” accounts.
If the account is used as savings in a portfolio approach,the money will not be in the account for too long. Children should use the account as a current account and start to manage their own finances.
If bigger sums are allo cated for deposit, National Savings offers tax-efficient products suitable for a child's portfolio. The maximum unit holding per children's bond is £1,000 and a bonus is paid on the fifth anniversary. The current interest rate is 5.25 per cent annually.
The National Savings inv est ment account offers 4.6 per cent over £500 and the first £70 of interest is tax-free.
It should be noted that children have exactly the same tax allowances as adults although most children are non-tax payers. Most children will be entitled to receive income gross. If they have a building society account, a parent or guardian should complete Inland Revenue form R85. This ensures that interest is paid without tax deducted until April 5 following the child's 16th birthday.
If adults, and this often involves grandparents, want to create a nest egg for children, some degree of equity exposure could be wise. This is for two very good reasons – gre ater growth and tax-free products. Investing for children is, by its very nature, long term and this makes an equity-based portfolio ideal. As children are rarely taxpayers, it is unlikely they will need to use their CGT allowances when investments are cashed.
There are thousands of equity-based products, but not all are suitable for children. A good entry-level for children into equity backed investments is a children's bond from a friendly society. The societies themselves are often overlooked due to the funding limits placed on their traditional plans, but they have their own advantages. The ceilings placed on contributions make the products suitable for children. It is a level of funding they can comprehend and is also comfortable for grandparents to afford.
The investment limits are £25 a month or £270 a year and the plan must be in force for 10 years to qualify for the tax-free status. Once the 10th anniversary has been achieved, it is possible to arrange for the plan to continue for anything up to 25 years, with tax-free investment continuing right up to maturity. One bond can be allocated per child.
The tax-free growth potential offered by friendly societies can prove especially attractive when it is remembered that equity Isas are not available to those under 18. The bonds can also be timed to mature on a special birthday – 18 or 21 for example – so that the tax-free funds are locked away for a time when they are probably needed most – for university or for a deposit on a first home.
Fund performance is also generally good. As a sector, friendly societies have consistently outperformed equivalent life funds.
While friendly societies provide a first base for a child portfolio they are by no means the only solution. If there is more money available for investment there are many familiar products to select but there can be poss ible tax implications. Children cannot own Isas but they can own shares, unit trust and investment trusts. Gifting these products to children carries a tax burden.
Income earned by a child on gifts from its parents need special attention – if the income generated by the gifts made by one parent to one child exceeds £100 in any one financial year, the parent is liable to tax on that income. An account that produces this income cannot be registered to pay interest gross, even if the parent's gift comprises only part of the capital.
Most commonly, the investment will be made by an adult on the child's behalf via a designated account that allows the adult to trade, buy or sell, with ownership resting with the child for tax purp oses. Most investment hou ses will be able to smooth the administrative path towards this sort of arrangement.
However, because gifts from anyone other than a parent are not subject to the £100 rule, any tax paid on income from these gifts because they are lumped in with the parent's contribution can be reclaimed on behalf of the child. As for CGT, it is unlikely to be much of a problem, since children can receive gifts from their parents without liability.
Trusts also have a place in planning for the passage of wealth from one generation to the next, especially if the grandparents are keen to endow their younger relatives. When preparing a legacy of this kind, care has to be taken and legal as well a financial advice should be provided.
Financial advice for children should follow the same guidelines as for adults if real capital appreciation is req uired. Risk can only be taken after a suitable amount of deposit-based funds are established. The creation of a portfolio built upon solid foundations of low equity commitment, gaining in complexity, as additional funds are committed is more relevant to today's than ever before.