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Brothers in alms

The Smiths are keen to implement a savings strategy for their two children – James, who is seven, and new arrival Matthew.The grandparents have said they will help but the Smiths are confused. What should they be advised?

Decisions about where to invest money for children are no longer straightforward since the arrival of stakeholder pensions and the child trust fund.

James and Matthew are lucky that family members, as well as their parents, are looking to their future.

As the current hot topic, the child trust fund is an easy place to start in considering investment for these two boys. As with most things, there are advantages and drawbacks. Only children born on or after September 1, 2002 will be eligible for the child trust fund. So Matthew will be entitled to an initial payment but James will get nothing.

The standard initial contribution from the Government is 250 although the actual amount paid is being raised slightly in recognition of the fact that it has taken some time for this legislation to be put into place. Children born between September 1, 2002 and April 5, 2003 will get 277, those born in the next tax year will get 268 and those born after April 6, 2004 will get 256.

Extra money is payable for those receiving child tax credit and children in care. All children will then receive another payment at age seven.

Family, friends and even Matthew himself when he is older can make additional contributions of up to 1,200 a year. Years are counted from the date of opening the account until the child’s birthday and annually thereafter.

There are tax advantages on the growth within a fund. As the child trust fund is modelled on the Isa, income and capital gains will arise free of tax although capital losses will not be allowable. Assets in a child trust fund will be treated separately from other identical assets for the purposes of CGT identification rules. The maturity proceeds payable at age 18 will also be tax-free.

The Smiths recognise these benefits but wonder if investing this amount of money on an annual basis is rather generous for their little ones. They should be advised that this is not so. Asked what they would want the money to be used for, they hope that a university education is on the horizon. With the current estimated cost of a three-year course being 26,400, by the time Matthew reaches 18 they will need 41,200, assuming 2.5 per cent inflation. So additional contributions are a necessity.

The Smiths feel that equal investment for James is only fair. This problem will be faced by lots of parents who have children who are not eligible for the child trust fund.

It might be a good idea for the Smiths to undertake the additional investment on behalf of Matthew and for the grandparents to make payments on behalf of James. The parental settlement income tax anti-avoidance rule does not apply to the child trust fund, so money given to Matthew by his parents for the child trust fund will not be assessed for income tax on their behalf should the income exceed 100 gross a year.

In contrast, as James cannot have a child trust fund, they will be caught by this rule if they are funding for him. This will not be the case if his grandparents invest for him. In addition, as the grandparents are likely to be able to afford a regular monthly payment for James from their income, there are no inheritance tax implications of their gifts.

But how much will be needed to ensure equity between the brothers? Illustrations will be needed to establish the benefits of a maximum child trust fund investment after 18 years. Alternative products will then have to be considered for James and a monthly premium calculated to target the same outcome as the child trust fund.

James can get exemption from income and capital gains tax on an investment of 25 a month or 270 a year if held within a friendly society bond.

As well as a traditional deposit-based account, James could also have a unit trust designated for him but there are no tax breaks here at all.

Undoubtedly, higher monthly amounts will need to be invested for James if the brothers are to be equal – a moral dilemma for the Smiths, along with the parents of some nine million other children in the UK not eligible for the new fund.

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