Investing on behalf of children
Investing can offer higher returns than savings products, but it's riskier than saving and you could lose money. This is true whether you’re investing for your own future or that of a child. In addition to this, investing on behalf of children has more specific considerations which you’ll need to weigh up. One of these is the question of whether you want to invest in a junior ISA, or in shares and funds held in a trust.
Junior ISA or funds?
Junior ISAs can also be invested in stocks and shares where the investment rolls up tax-free. So no income tax is payable on dividends paid by the fund, or on any capital gains.
However, as children are usually non-taxpayers, they’re unlikely to pay tax on share or fund dividends anyway. They also have their own annual capital gains tax allowance of £11,100, which means they can sell shares or funds and, as long as any increase in value is less than £11,100, there’s no tax to pay.
Like bank accounts, there’s a choice between holding investments within a junior ISA, or directly in shares or collective funds such as OEICs and unit trusts.
One complication is that only those who are 18 or older can start an OEICs or unit trusts. And, although children can own shares directly, many companies prevent under 18s from holding their shares.
There are two potential solutions to this problem:
1) An adult owns the funds or shares and ‘designates’ the funds or shares in the child’s name. This practice does not mean that the child legally owns the funds/shares, but rather it acts as a way of separating these investments from the adult’s other investments. As the adult owns the shares, tax is based upon the adult’s tax status. So this option is less tax efficient, as it doesn’t make use of the child’s allowances.
2) Place the shares or funds in a ‘bare’ trust (also known as an ‘absolute’ trust). Under this type of trust, the child is the beneficial owner of the investments. This means the trust ‘looks through’ to the child’s tax situation, so any income and capital gains tax usually falls on the child. However, if the money gifted into the trust comes from the parents, the income (above £100 a year) and gains will be taxed on the parents’ tax status. Like the junior ISA, any money remaining in the trust at age 18 legally becomes the child’s money.
A stocks and shares junior ISA or shares/funds held in a bare trust?
Each of these options has its own pros and cons, depending on your own priorities and circumstances. Directly comparing some important characteristics of each could help you decide which may be an appropriate choice...
A stocks and shares junior ISA:
- Less hassle. There’s no need to worry about whether the income or gains are within allowances.
- Easier to set up and run – no need for trustees to be appointed.
- Can cover investments of up to £4,080 a year, which will easily cover the needs of most people.
- Locked away until age 18, meaning that no one can touch it until then.
- Can be set up with gifts from parents (and anyone else) without the income or gains belonging to the parents.
Shares/funds held under a bare trust:
- Not as difficult to set up and administer as you might think. The trustees’ main role will be to agree investment choices and withdrawals.
- Unlike the junior ISA, withdrawals can be made before age 18 to pay for something that will benefit the child – such as school fees or maintenance costs.
- By acting as trustees, parents and grandparents potentially have more control (until the child reaches age 18) than they would have with a junior ISA.
- Unlike the junior ISA, there is no annual limit on investments. This means that the child’s income and capital gains tax allowances can be fully utilised.
- Useful for gifts from people other than the parents; for example, grandparents or other relatives.
Inheritance tax rules treat gifts made into junior ISAs or bare trusts as ‘potentially exempt transfers’. If the donor lives for 7 years after making the gift, then the gift falls outside their estate when calculating inheritance tax. If the donor dies within 7 years then the amount of the gift still counted as part of their estate will vary between 20% and 100% depending on how many years have passed since the gift was made.
Regular investment or lump sum?
Investing regularly is generally less risky than investing a lump sum. That is because you are buying investments at the prevailing price each month or each year over a longer period. This means you will buy investments at closer to the average price rather than at the highest or lowest prices.
If you have concerns about investing a lump sum because of current market conditions, think about splitting up your investment and investing gradually over 12 or 18 months.
Pensions for children... not as daft as it sounds?
The concept of saving into a pension for your child’s future benefit may seem a bit daft. After all, a child is unlikely to get their hands on those gifts for another 50 or 60 years.
However, like any savings goal, the earlier you start, the greater the benefit of compound returns.
For example, assume parents save £800 a year (£66.67 a month) into a pension for their child from birth to age 18. The government would add tax relief of £200 a year, meaning that £1,000 would be invested. If that money grew at 3% a year above inflation, then the child would have around £100,000 at state pension age ( 67), in today’s money terms. That would be enough to buy an annual income of £5,000 a year for life at current annuity rates.*
Like all other non-earners, children are allowed to save £3,600 a year including tax relief (net cost £2,880) into a pension. Anyone is allowed to pay in contributions on a child’s behalf, but the tax relief rate is based on the child’s tax situation rather than that of the donor, which in most cases will be basic rate (20%) tax relief only.
Another reason why gifting money into a pension may appeal is precisely because it is so inaccessible. We’ve seen that gifting money via junior ISAs, bank accounts or bare trusts results in the child becoming entitled to the money at age 18. But some parents and grandparents may prefer that the money is locked away for longer.
Documenting the source of gifts
One important point worth mentioning is the need to document gifts.
We have seen that any gifts from parents to child are ineffective in using the child’s income tax allowances, because any income above £100 a year is deemed to be the parents’.
However, the income will be regarded as the child’s if the money is gifted by others, such as grandparents or aunts and uncles. So, ensuring that the source of the money can be traced back to someone other than the parents is important if the child is to be allowed to set the income from bank accounts and investments against their personal income tax allowance.
Another important reason for documenting gifts is inheritance tax. In this case, it is the donor – the person gifting the money – who needs to prove that they actually made the gift, particularly if the gift is made out of normal income.
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Having a specific aim in mind – such as education or a foot on the housing ladder – can affect the choices you make for saving or investment. We’ll guide you through some options.