Child Trust Fund

How much can you afford to put aside for your new grandchildren? Now is the time to decide because from April next year every child born on 1 September 2002 or later will be able to have a tax-free savings account that parents, grandparents, relatives, friends and anyone else can pay into. The limit is £1200 a year between them and to start it off, the Chancellor is putting in a tax-free present of at least £250 which does not count towards that total. He has promised another, probably similar, amount at the age of seven. And there is twice as much from Gordon for families where the parents have a joint income below £13,480 a year and are claiming their full child tax credit.

The new account, which is called a Child Trust Fund (CTF), and the state cash were originally announced by the Chancellor in Autumn 2002. Children born between September 2002 and April 2005 will be given slightly more than £250 to make up for the lost investment return between their birth and the time they can invest the money next year. The amounts are shown in the table.

The money should arrive in the first three months of 2005 – though it cannot be used until April. It will be paid as a voucher which will be sent to the person who receives the baby’s Child Benefit. The voucher has to be put into the CTF, which is a bit like an ISA for children. CTFs will be run by banks, insurance companies, larger building societies and possibly by some credit unions. Although the money from the Government is not very much by itself, if everyone chips in the total can add up very nicely. For example, if relatives put in the maximum £1200 a year from birth then with the government’s £250 at birth and assuming another £250 at 7, a total of £22,100 will have been paid in. If that is in a cash deposit account earning 4 per cent that will have grown to £32,897 by the time the baby becomes an adult at 18. Of course, if no-one contributes to the fund apart from the Government then the figures are less rosy. Assuming the Government’s second contribution is the same as the first, the £500 the Government has paid in will be worth just £891 when the baby reaches 18.

There is no tax relief on the money paid in. But once there, all the interest it earns and any growth in its value is tax-free – and does not affect the tax position of parents even if they have paid money into the CTF. If the money is invested in shares the dividends are paid with basic rate tax deducted and the Fund cannot reclaim that money. So, as with ISAs, the tax advantages are limited for stock market investments.

When the child reaches 18 the money is theirs and they can do what they like with it. Parents may hope they will put it towards their university education or their first home. But there is nothing to stop them blowing the lot on a party, a car, or a trip round the world.

There will be different kinds of Child Trust Fund with a variety of ways to invest the money. These will range from cash savings accounts to investments based on the stock market. The cash savings account has two great advantages. First, there is no risk. Second, the CTF provider will not make any charge for running it. In that sense it will be like a building society account or a cash ISA. With other kinds of investment, though there will be charges to pay – possibly an upfront fee and certainly an annual fee taken off the money invested. All providers will have to offer at least one CTF account called a ‘stakeholder’. That will be invested partly in shares and there will be a maximum charge of 1.5 per cent of the Fund each year. No initial upfront charge will be allowed. Much of the 1.5 per cent deducted will be used to promote the scheme and pay commission to IFAs. It is these accounts that will be promoted by the financial services industry.

The effect of even ‘stakeholder’ charges will be considerable. For example, a fund that grows by 7% a year every year on the maximum contributions the fund would be worth just over £45,000 at age 18. But with the full charge of 1.5 per cent a year, the fund in effect grows by 5.5% a year and would be worth only £38,400 at 18. In other words £6,600 of the money invested and earned has been drained away in charges and commission – about £1 for every £3.50 the money should have earned. Of course, there is no guarantee that the fund will grow by 7 per cent a year. Over the last 18 years an investment in shares with all the dividends reinvested has grown, after inflation but before charges, by about 6.5 per cent a year. More recently things have been worse. From the middle of 1995 a fund invested across the whole stockmarket would be worth no more today, after charges and inflation, than it was then. Indeed, there have been periods in the distant past when the value of an investment in shares was actually worth less after 18 years than when it began. So stockmarket based investments are always risky – though overall over the last 100 years they have done better than safer investments such as cash. Remember too that the 5.5% growth after charges is not much less than you can get guaranteed without charges with a cash savings account.

Apart from shares and cash, there will be other options available including corporate bonds, which are less risky than shares, and Government stock or gilts which are almost as safe as cash. Stakeholder CTFs will have no more than 60 per cent of the money in shares and that proportion will fall as the holder approaches the age of 18.

If the parent has not used the voucher to open a CTF for a year after it was issued, then the Inland Revenue will open an account on the child’s behalf. This will always be a stakeholder account.

OLDER CHILDREN
Children born before 1 September 2002 will not be eligible either for a Child Trust Fund account or for the £250 gift from the Government. But parents and grandparents can still save up for their offspring. There is a wide range of accounts which have the label ‘children’ but most of them are poor value. They often come with free gifts ranging from the traditional moneybox to vouchers for CDs. But these ‘gifts’ come at a price as rates of interest are usually not as good as the best standard savings accounts, which can always be opened for a child and which can pay nearly 5 per cent.

If you want to tie the money up for a year or more you would do better to buy a fixed rate bond from, for example, Birmingham Midshires, Abbey or Alliance & Leicester which are currently paying more than 5 per cent on one year bonds and sometimes slightly more on two or three year bonds.

Interest on these savings accounts and these cash bonds can be credited gross as long as the parent signs a form R85 stating that it is an account for a child who is not a taxpayer. But if the child’s account earns interest of more than £100 a year on money given by a parent, then the whole of the interest is taxable as the parent’s income. This rule applies separately to money given by fathers and mothers. So if Dad puts £2,000 into an account for a new baby at 4.75% it will earn £95 a year interest and that will not be taxed. If Mum also does the same that will not be taxed either.

This tax rule only applies to interest on money given by parents. The interest earned on money given to a child by anyone else, including grandparents, is treated as the child’s income and is not normally taxed – unless the child is lucky enough to have an income above £4,745 a year.

If the account is in the child’s name then at a certain age they will be able to take control of it themselves. With a saving account that age is usually between 7 and 11. Although the child will normally have to be about 12 before staff will be happy to let them withdraw cash without parental supervision. The age is 16 for some products from National Savings & Investments including the Children’s Bonus Bond which currently pays 4.7 per cent a year if held for five years. Children can’t own shares until they reach 18, so an investment in a shares-based fund has to opened by an adult in their own name but ‘designated as’ the child’s account. That in effect creates what is legally a ‘bare trust’ and the adult controls the investment on the child’s behalf until they reach 18.

Many friendly societies and insurance companies offer special stock market based investments for young savers often named after furry animals. But charges can be high, conditions can be inflexible and investment performance has often been terrible. They are best avoided.

You can now compare savings accounts through the official tables published by the financial regulator www.fsa.gov.uk. But note that not every account is included.

FREE PASSPORTS FOR OVER 75s
Everyone born on 2 September 1929 or earlier will be eligible for free passports from this autumn. The concession is intended to reward those who were at least ten years old at the start of World War Two. The free passport will apply whether you already have a passport or not and in effect means that anyone of that age will in future get passports free, either a new one or a renewal, instead of paying the full price. That is currently £42 but may rise further when new security measures are introduced.

August 2004

e-mail Paul Lewis on paul@paullewis.co.uk