Thursday, 20 September 2007

Tax-Free Saving for Children in the UK

What is the best way to save for the future for a child in the UK? Recently, that question was put to me by a family member who had seen a TV program in which Martin Lewis of the MoneySavingExpert has said something to the effect that an ordinary child savings account at a bank or building society could give a higher tax-free return / rate of interest than specialized products such as Child Trust Funds. I decided to take a very broad approach to comparing the options, including using a parent's ISA or other investments like National Savings and Investments various tax-free bonds. It turns out that there are a number of excellent alternatives all offering tax-free saving but which differ considerably according to flexibility, control of the funds, types of risk, likely after-inflation returns, ease of investing or topping up and amount of effort to manage.

Child Trust Fund
Every child born in the UK after September 1, 2002 gets a CTF, courtesy of the government which provides a £250 voucher (plus £250 extra for low-income families) that parents can use to open a CTF account. If you don't bother opening one yourself, after a year the government will open one for your child with the voucher and pick a provider at random, so you'd be just as well do it and choose yourself. The government adds another £250 (plus £250 again if eligible) when the child reaches age 7. You have a choice of one of three types of CTF available - 1) a savings account with a bank or building society, 2) a stakeholder equity account and 3) a self-select equity account. You can change from one type of CTF to another later on without penalty.

The CTF ''wrapper'' imposes certain common rules that should be considered when deciding how much of the savings for the child should be deposited in it. The first is that the funds are locked in till the child is 18 and cannot be withdrawn, not by parent nor child. The second is that the funds belong to the child, not the parent (or the government). At 18, the child can do absolutely whatever he/she wishes with the money. If you have doubts about whether the child will spend the money wisely at 18 and blow it all on frivolities, then you may want another type of vehicle. On the other hand, isn't part of your job as a parent to teach your kids how to handle money properly? They can't be children forever.

One additional good thing about the CTF is that the child can choose at age 18, when the account must be closed and the funds paid out, to transfer the whole amount into an ISA, which allows it to continue to grow tax-free. Given that the balance in the CTF may have grown far above the annual contribution allowed of £7000 for an ISA, that provides a way to avoid feeling that the money must be spent immediately. Perhaps the 18-year old will want to save further for a house purchase.

In other words, the CTF is meant to be a long-term savings vehicle. If you think you might need the funds before then, you should use another tax-free savings method. To my mind, the CTF should not be invested in a savings account, whose chief merit is to be safe from loss / decline in value in the short term, but whose long-term return is minimal after inflation. Instead the CTF should be in equities of some sort, either the Stakeholder account or the Self-Select. As I described in a previous post on Stakeholder CTFs, all such CTFs are invested in some form of UK Index Tracker Fund. F&C's is the best of the lot since it has slightly lower fees (1.22% per annum vs the usual 1.5%, which is the legal cap on this type of CTF). You don't have to watch the stock market and worry what to do since you are just getting the UK market average, a very good thing for busy parents who don't have the time or inclination to be an investment expert. In fact, it's best to ''file and forget'', ignore the market ups and downs, just let it grow on average over a long period as equities show their long-term superiority over savings. The Stakeholder CTF is the ideal way to have a no maintenance investment in equities for amounts up to perhaps £2000. Above that, a Self-Select Share Dealing CTF offers the opportunity for lower overhead costs and better diversification. My preferred choice there is Self-Trade due to its zero annual account admin fee, though The Share Centre is a close second because of its low trading fees. Why diversification? The UK is not the only market in the world and good investment practice is to include holdings from around the world and in other types of assets such as real estate. The Self-Select CTF accounts offer the ability to invest in any type of equity, or bonds available on the UK market, though I am partial to ETFs ( and not OEICs or other types of actively managed funds). There is apparently now even a shari'a compliant CTF for Muslim parents. I would put all the CTF money into equities and not any into bonds or cash-type fixed income since the other types of tax-free vehicles below can meet those needs and provide total portfolio balance of equities and fixed income. The chart below shows the detail of the terms and conditions.

Individual Savings Account (ISA)
An ISA is another tax-free account wrapper that enables various types of savings and investments free of income or capital gains tax. It is really a product for adults - you must be at least 16 to have one in your own name - but parents can use their own annual allowance of up to £7000 to save for the future needs of their children or themselves. The funds within the account are under the complete control of the parent/adult and can be withdrawn at any time. The money of and for the child is mixed in with the adults' own money.

Normally, this shouldn't be a problem, unless the parents themselves are spendthrifts and cannot save or unless a situation like a marital break-up complicates matters. Grandparents, other relatives or friends who may wish to contribute may feel more comfortable giving money to a child when it is clearly in his/her name. Better, I believe, to establish a formal and psychological barrier between what belongs to the child and what is the parents', i.e. not use ISAs at all for children. Anything invested for the children reduces the amount that parents can save tax-free for themselves. In any case, the £250 government voucher cannot be put into an ISA, only into a CTF.

ISAs from different institutions offer the same range of investment alternatives as CTFs - everything from bank and building society savings accounts, to investment funds, to self-select investment accounts. An additional player is National Savings and Investments, which offers two types of mini cash ISAs (whose annual contribution limit is £3000). The one in the table below on the best ISAs, shows the higher-yielding alternative, the Direct ISA, which can only be managed by phone or on-line. The other one, the Cash Mini ISA, currently pays about a percent less at 5.35% but it can accept additional contributions of as little as £10 at a time (vs £100 or £250 for the Direct ISA), better for those of more modest ability to save.

Child Bonus Bonds and Index-Linked Savings Certificates
These two investments are available only from National Savings and Investments, a government agency that started out as the Post Office bank (which explains why Post Offices in the UK display racks of NS and I brochures). Both types of investment are automatically tax-free. Both belong legally to the child and in-trust forms are available for non-parents to buy the bonds for children under 7. It is interesting that the Index-Linked certificates can be controlled by a child 7 or over ... hmmm, imagine a 7 year-old with £15,000 under his/her own control.

Both are better considered for medium-term three to five year investments. Though the funds are not locked-in and can be withdrawn on demand, interest is not earned at all or is considerably reduced if the funds are withdrawn early. A week ago, it might have been said that the direct backing of the government provided extra protection from loss than other bank accounts, but now that the Northern Rock debacle seems to confirm that no bank depositors will be allowed to lose their money, that seems to be a moot point.

The interest rate offered is almost identical - 5.1% vs 5.15% - but the index-linked certificates offer a guarantee that they will beat UK inflation by 1.35%, not a lot, but that eliminates the major risk of fixed rate investments, that inflation will reduce their value in real terms. I think I'd rather have the Index-linked Certificates. The table below gives the details of these two savings alternatives.

Child Savings Account at Bank or Building Society
Yet another alternative is to open an account in the name of the child at a bank or building society. Very many, if not all, such institutions offer them. The advantage is that most often a higher rate is offered. In the quick search for the best rate from the MoneySavingExpert's website, the Chelsea BS had the highest the day I did it, but it can and does change almost constantly and that's the problem. Unless you are prepared to be checking the website and changing banks frequently, a hassle in itself, you wouldn't be getting the absolute best rate for long. On top of that, at some point down the road, the bank/BS might just drop the rate without notice, a point that MoneySavingExpert warns about. There's also a limit of £100 interest per year that the child can earn from a parent's gift (the idea being to quash parents hiding their own savings in children's accounts), which equates to about £1600 max in the account. In order to avoid tax being deducted automatically (at a tax rate of 20%) from the interest earned on the account, you must fill in form R85 (said to be normally available at the bank branch) and send it on to HMRC, which is a bit of extra work, though only needs to be done once. Despite the complications, such an account may still be a valuable tool for a child to learn how to save and spend money under his or her own control. The table below gives details of a Child Savings Account.

Bare Trust
Not to leave out any, another option is the bare trust which is, in the definition of HMRC:
''A bare trust, also known as a 'simple trust', is one in which each beneficiary has an immediate and absolute right to both capital and income. The beneficiaries of a bare trust have the right to take actual possession of trust property.

The property is held in the name of a trustee. But that trustee has no discretion over what income to pay the beneficiary. In effect, the trustee is a nominee in whose name the property is held. The trustee has no active duties to perform.''

The child is the beneficiary and gets taxed at his or her rate on dividends and capital gains, which is usually lower than the parents'. The £100 limit on interest income from funds donated by each parent applies to a bare trust as well so the maximum benefit accrues when non-parents donate funds for the trust. Bare trusts are used to reduce inheritance taxes and are most appropriate when many thousands of pounds sterling are involved given that professional legal and accounting advice to set things up correctly is highly recommended e.g. see this UK DirectGov website on trusts.

Since the alternatives are not mutually exclusive, I tend to feel that the best course of action is to spread things around and utilize several simultaneously.

Other Websites with Useful Info - see Savings and Investments in Your Money section
Child Trust Fund Official website

1 comment:

Anonymous said...

The Bare Trust is a long term financial tool that shold not be overlooked. In order to minimize tax impact, it is best ot contribute smaller amounts over longer periods of time. Lesson, planning ahead for intewrgenerational transfer of wealth can save big money and benefit those who are intended to benefit the most...your children.


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