Investing in a child’s future has arguably never been more important. Cost of living continues to rise above inflation each year, wages have stagnated and university tuition fees have increased from £3,000 to £9,000 per year. If children are to have a good chance of progressing through life when they leave school, their families must be prepared to foot the bill. As the economy shows little sign of making a full recovery, parents would be wise to start investing in their children’s future as soon as possible.
Many people believe that children escape taxation, which of course, is untrue. Though children are not required to pay all kinds of tax, they are just as subject to rules on income tax as adults. While children cannot enter full-time employment until a certain age, the interest they make on savings does count as income.
So children can be charged income tax when they make money from savings. Likewise, tax may be payable on dividends or profits generated by investments in stocks and shares. The important factor to consider is whether the child’s income for the tax year exceeds the personal allowance set by HMRC, which is £8,105 for 2012-2013. Parents should also note that another tax threshold exists for savers. After the personal allowance is deducted, income from savings is taxed at the starting rate of 10%, if interest does not exceed £2,710 (2012-2013).
There is another obstacle involving tax that parents need to consider before investing in their children’s future. The so-called £100 rule applies, when parents give money to their children that produces over £100 in interest or income. Established in part to prevent tax fraud, the £100 rule works by taxing the child’s income from savings as the donor parent’s income. Unfortunately, children are unable to claim back this tax, which is automatically deducted from interest.
One solution to the £100 rule exists in the form of the Junior ISA (Individual Savings Account), which is available from various financial institutions, including banks such as Lloyds TSB and Barclays. There are two types of Junior ISA: cash Junior ISA and stocks and shares ISA.
The cash Junior ISA is arguably one of the most useful types of savings account, as the interest it generates is tax free. Parents can bypass the £100 rule by investing up to £3,600 per year (April to April) in a cash Junior ISA, until their child reaches the age of 18.
Interest accruing from savings in a cash Junior ISA may be fixed to (or typically slightly above) the Base Rate after the introductory period. This means that interest of 3-5% may be possible in the first year, before the provider drops the rate to 0.5-1.5%. Fortunately, parents can switch providers after the introductory period. Though sometimes this can be a hassle, it does allow parents to obtain the best rates available.
Cash Junior ISAs provide a reliable source of savings income for children. If parents save the maximum deposit allowance every year, a 12-year cash Junior ISA could produce more than £45,000 for their child when he reaches adulthood.
Stocks and shares ISAs are somewhat riskier for parents, but they can produce greater gains. Acting as an investment vehicle for parents who want to maximise their children’s savings potential, stocks and shares ISAs use deposits made by parents, to create a trading portfolio. As stocks and shares are bought and sold over time, the trading balance should increase each year. Though at greater risk of failure, this type of ISA can produce substantially more income than cash Junior ISAs.
Standard savings accounts
A number of financial institutions offer more generous interest rates for private savings accounts than government-backed ISAs. Although parents are subject to the £100 rule, which typically limits their capacity to set up and invest in private savings accounts for their children, other family members should be able to contribute gifts without penalty.
More money can also be invested in private savings accounts than cash Junior ISAs, but higher (or non-existent) savings limits do come at a price. As noted above, interest is treated as income by HMRC. If a private savings account generates substantially more than the personal allowance in a tax year, the child is likely to have to pay tax. The extent to which this is a problem depends on the rate of taxation and the amount of money the child loses each year.
Information kindly supplied by Baines & Ernst – financial solutions specialists who have been helping people get out of debt since 1996