Children can earn up to pounds 100 a year in interest on money given by a parent before they start having to pay tax. After that they will be taxed even though they will not have used up their personal allowance (the same as adults at pounds 4,195), and will pay it on the whole sum at the parents' highest rate of tax. The pounds 100 limit is per parent, so the limit would be pounds 200 on capital from both parents.
However, interest earned on money given by relatives such as grandparents or uncles, and even friends, is tax-free up to the child's personal allowance.
Fiona Price, an independent financial adviser, warns against sinking too much money into an investment plan when a child is born, because other children may follow and fairness may dictate that you save the same amount for them.
A traditional starting point for investment has been a National Savings Children's Bonus Bond paying 5 per cent a year. To earn this rate, you must invest the money for at least five years. The minimum investment is pounds 25 and the maximum pounds 1,000. Income earned is always tax-free.
David Bernfield, life and pension manager at Colin Ryan insurance brokers in Ipswich, directs his customers to friendly society baby bonds. Offered by many of the 300 friendly societies nationwide, including Tunbridge Wells Equitable and Family Assurance, these bonds allow you to invest a maximum pounds 25 a month or pounds 270 a year with growth free of tax.
You can either link your investment to shares or take out a with-profits bond if you wish to smooth the volatility of the markets. Mr Bernfield recommends the Tunbridge Wells Baby Bond, which can be either unit-linked or with-profits.
The with-profits bond guarantees a minimum pounds 5,457 on a pounds 25-a-month investment over 20 years, but it could be worth much more depending on growth. With 6 per cent a year growth, it would have an estimated maturity value of pounds 9,100.
Many parents see these bonds as a means of paying for university fees, but a friendly society investment won't be enough: with costs estimated at pounds 5,000 a year now, you will have to save a lot more than that to pay for your child's college education in 18 years' time.
Many banks and building societies target children with specially named deposit accounts, and many allow accounts to be opened with a low deposit. Birmingham Midshires currently pays 7.75 per cent on a minimum pounds 25 deposit with instant access on its Smartstart account, rising to 8 per cent on deposits over pounds 500. Bradford & Bingley pays 7 per cent on a minimum deposit of pounds 10.
If you hope to make a lot more than this for your child, you will have to invest on the stock market. "Most people invest until the child is at least 18," says Ms Price. "Over such a long period regular savings plans will grow impressively, and shares should ride out the ups and downs of the market."
Most fund managers run regular savings plans where you can put in a small amount and stop at any time without penalty, leaving your investment to grow. You can invest lump sums, say, on your child's birthday or at Christmas.
Edinburgh Fund Managers runs a trust called the Saving for Children Plan, with a minimum investment of pounds 20 a month. In the 10 years to October 1998, Edinburgh's figures show that a pounds 1,000 lump sum investment in the plan would be worth pounds 3,863, compared with pounds 1,901 put into the highest-rate building society.
Contacts: Birmingham Midshires, 0645 720721; Bradford & Bingley, 01274 555332; Edinburgh Fund Managers, 0800 838993; Family Assurance, 01273 724570; Flemings, 0500 500161; Homeowners Friendly Society, 01423 844000; Nationwide, 0500 302010; Tun-bridge Wells, 01892 515353.