Giving financial gifts to children

Your child or grandchild may want the latest toy this Christmas, but how about giving them a present that will help their financial future?

Gifts of the financial variety might have a longer lasting impact. It may encourage children to save or start a fund which could count towards university costs, for example.

The government is trying to encourage saving at an early age, through its new Child Trust Fund. The first vouchers, worth £250 or £500 for low-income families, will be distributed from January. All children born after 1st September 2002 will be eligible. Parents will need to decide which financial institution will manage this gift in time for the start of the scheme in April 2005.

Parents and relatives will be able to top up the fund with up to £1,200 a year, which will grow free of income and capital gains tax. As the Child Trust Fund will not be in force in time for Christmas, relatives could invest their gifts in a higher rate children's deposit account, and use this as a feeder fund.

There are accounts designed to start children off in the savings habit and they often pay a higher rate of interest. Some of the best instant-access accounts currently available include the Ladybird account from the Saffron Walden Building Society, paying 5.35% for a minimum balance of £1 and the Alliance & Leicester FirstSaver which pays 5.25%, also starting at £1.

Interest earned by children is subject to income tax. However, children, like adults, have a personal income tax allowance (£4,745 for the current tax year).

If the account holds money gifted by friends and relatives - but not parents - any interest earned from the savings account may be set against the allowance. As long as the total amount of interest falls within the allowance, then no tax will be payable. When the account is opened a form "R85", available from the bank or building society, should be completed. This confirms that the account holder is a non-taxpayer and allows interest to be received without the deduction of income tax.

The tax rules are different for parents who save on behalf of a child. Only £100 of interest (per parent) can be tax-free. Where interest exceeds this level, the whole of the interest will be taxed on the parent. This is to prevent parents from holding their own cash savings in their children's names and taking advantage of the tax allowances. Where both parents and other relatives are saving on behalf of a child, consideration should be given to opening separate accounts - one for parents' gifts and one for gifts from other relatives. Therefore, it may be preferable for parents to contribute to the Child Trust Fund which is tax free, with any gifts from relatives that take the total above the annual £1,200 limit being directed to a deposit account.

Another favourite solution is Premium Bonds. With the promise of riches far greater than a mere deposit account, they make great presents. The parent or guardian will be responsible for the Bonds and will receive notification of the purchase. Any prizes will be sent to the parent or child's guardian. The minimum for each purchase is £100 and Bonds are sold in multiples of £10.

There are gift opportunities beyond cash accounts and these should not be ignored.

Over the longer term, stock market funds have outperformed other types of investment, although in the shorter term they can be volatile. One of the benefits of investing for children is that investment is generally for the longer term - more than ten years - which helps to reduce the risks associated with investing in shares. One way to spread the risk is to invest in the stock market through a unit or investment trust. These are pooled investment funds which give access to a wide range of shares. These funds may be actively managed, where a fund manager picks individual stocks based on a view of their future potential, or passive, where a manager invests in all the shares that comprise a stock market index, for example, the FTSE 100. Exchange Traded Funds offer an alternative way to track a stock market. These are single shares that give the return of an underlying index (so are really another form of tracker). The difference is that the charges are quite low. The only drawback with all financial gifts is that the children gain an absolute right to the money at age 18, and parents will have no control over how it is spent. For larger gifts it may be worthwhile taking professional advice on the establishment of a suitable trust that will allow ongoing control over the capital and income.