Savings that grow up

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WHEN parents deliberate over the right investments to safeguard their children's financial future, they often overlook the fact that children are entitled to a tax-free income of their own. Using a child's tax-free allowance should have a place in every family's financial planning.

Children, like adults, are allowed income of up to pounds 3,525 a year before they have to pay tax. This threshold will rise to pounds 3,765 in April. And like adults, children also receive their own tax-free capital gains allowance of pounds 6,000.

However, money invested by parents - but not other relatives, or friends - for their children is restricted to a much lower tax-free income allowance of pounds 100 a year. Parents are taxed on higher amounts as their own income. As a result, anything that generates a high level of income has to be treated with care. Gifts from anyone other than a parent are not subject to the pounds 100 rule, and a child's full personal tax allowance will apply to any income from the investment.

Children are restricted in the type of investments they can hold. They cannot hold a Tax-exempt special savings account (Tessa) or a Personal Equity Plan (Pep)in their own names, but they can hold individual shares. Some company shares come with perks that will appeal to children, such as Thornton's shares, which give chocolate vouchers. But parents do not need to risk money on the stock market to help children take advantage of their tax allowance. Most banks and building societies offer children's accounts with rates that are usually higher than on adult accounts, around 4 per cent.

To prevent tax being deducted from the account at source, parents need to fill out an Inland Revenue R85 form, usually available at a bank or building society.

A better bet for growth is the National Savings Children's Bonus Bond, which can be bought by anyone over 16 for anyone under 16. The current issue G has an annual rate of 7.85 per cent, which breaks down into 5 per cent per annum for five years plus an 18.28 per cent bonus on the fifth anniversary. Interest is paid tax-free. The bond can be redeemed before the final year, provided one month's notice is given, but no interest is paid if the bond is repaid in the first year. Investments are sold in units of pounds 25, with a ceiling of pounds 1,000.

Friendly society baby bonds are also designed with children in mind. The danger here is in the steep charges (see separate article). A baby bond investment must run at least 10 years.

Another option is the unit or investment trust. Parents can set up the investment as an absolute trust in a child's name and reclaim tax on dividends and income. Dividends and income can be reinvested or paid into a child's building society account.

It is sensible to look for a fund that looks beyond the UK, with exposure to countries that promise growth, such as China.