Money: Tax-Free Savings - Kids' plans are no teddy bears' picnic

Spice girl dolls and Teletubbies may be all the rage this Christmas but if you want to give children a gift that will last, you could start a savings or investment scheme for them.

There are a number of tax-free plans, such as National Savings Children's Bonus Bonds, which pay a guaranteed interest rate for every five years they are held. The current H issue of the bond is paying 6.75 per cent a year, so pounds 1,000 invested now will be worth pounds 1,386.40 in five years. These bonds can be bought by anyone over 16 for anyone under 16 and can be held until the child is 21. You can invest as little as pounds 25 while the maximum holding in any issue is pounds 1,000.

Another tax-free option is Friendly Society bonds aimed at children offered by a number of societies including the Tunbridge Wells. Up to pounds 25 a month can be invested and providing the bond is kept for at least 10 years, the proceeds are tax free. Money invested in these bonds goes into a stock market fund, so the eventual return will depend on how well the fund performs.

But you also need to consider charges as these can be high. For example, the set-up charges on Family Assurance's Junior Bond can be up to 100 per cent of the first year's premiums. There is also an annual management charge of 1.95 per cent of the value of the fund. If you invested pounds 25 a month in the Junior Bond, and the investment grew by 9 per cent a year, at the end of 10 years the bond would be worth pounds 4,110 after charges. The effect of the charges is to bring the investment growth rate down from 9 per cent a year to 6.1 per cent a year.

These are the only tax-free investments open to children. "But as most children are non-taxpayers, they are unlikely to have to pay tax on interest from investments anyway," says Vivienne Starkey, a senior consultant with Haddock, Porter, Williams, independent financial advisers. "Children have their own tax allowance. Providing the money does not come from their parents and they don't earn interest above their annual personal allowance of pounds 4,045, almost any investment will be tax free. I'd recommend looking at the whole range of savings and investments before making a decision."

Many banks and building societies offer accounts for children that include free gifts. The best rates of interest are often paid by small, regional building societies, but you may only be able to open an account if the child lives locally.

Among the current top accounts are Britannia Building Society's FirstSaver account, which pays 7 per cent on balances of pounds 1, rising to 7.25 per cent on pounds 500 and more, Nationwide's Smart 2 Save account that pays 7.2 per cent, and Cambridge Building Society, which offers 7.5 per cent on its First account.

Interest on a bank or building society account is taxed, so if the child is a non-tax payer, complete tax-exemption form R85 when you open the account. An exception is National Savings' deposit accounts where the first pounds 70 of interest is tax free. Its top paying account is the Investment Account offering 4.75 per cent gross on balances under pounds 500 rising to 6.5 per cent on pounds 50,000 and over.

Also worth considering are Premium Bonds. Not strictly an investment, as they earn no interest, each bond is entered in the monthly draw with a chance to win between pounds 50 and pounds 1m tax free in prizes. The bonds, with a minimum investment of pounds 100, can be converted back into money any time.

If you are looking to invest for a child long term you should consider equities. Stock market investment over the long term, while risky, has proved far more profitable than putting money into a savings account. The best way to invest is through a unit or investment trust where money is pooled.

Some unit trusts and investment trusts are aimed at children, such as the Rupert Children's Fund. Run just like any other unit trust, the managers offer a free Rupert Bear gift when money is invested. "The minimum investments are low to make equity investment affordable to investors. We accept any amount from pounds 20 a month or a lump sum of just pounds 50," says Nuala Ryan, of Invesco, the managers. Fleming Investment Trust Services is also after the children's market. It is giving a free teddy bear to every adult who invests in one of its investment trusts on behalf of a child before the new year.

"When choosing a unit or investment trust, you should look first at the underlying investments," Ms Starkey says. "Look at where your money is invested, who is the manager and the charges on the fund. Ignore any free gifts as good performance and charges are more important."

The most common way of investing in an investment trust for a child is for the adult to act as bare trustee registering the shares in his or her own name, with the child's name or initials added to show the investment is for the benefit of the child. This is known as a "designated account". The rules are more or less the same with unit trusts.

Parents wanting to invest for their children should consider their tax own position. If the total income from these investments is under pounds 100 a year it counts as the child's income. If it is more, then the whole lot is taxed as if it were the parents' income. This rule does not apply when money is invested by grandparents, aunts or uncles.

q For a free copy of the AITC's guide on investing in investment trusts for children, call 0171-431 5222.

q Copies of Autif's free guide to saving is available by calling 0181 207 1361.