The DIY child trust fund

If you have a child born on or after September 1 2002, he or she will soon receive a gift of ?250 (or ?500 if your family receives child tax credit (CTF) and has a total gross income of less than ?13,480) under the government's child trust fund scheme.

You, your parents or friends are free to add a further ?1,200 a year to the fund, free of income and capital gains tax. In seven years' time, your child could be in line for another ?250, depending on how much the government of the time decides to contribute.

All of which is great, but what if your baby was born on August 31 or before? How can you invest in an equivalent way for children too old to qualify for the scheme?

The CTF scheme offers three investment options - a cash savings account, a shares-based account and a stakeholder account, which limits management fees to no more than 1.5% of the fund value and charges the fund manager with 'smoothing' the investment by diversifying into other, non-share based holdings in its later years. CTFs are held in the child's name, and they cannot get their hands on the money until their 18th birthday.

There is no exact duplicate form of investment, although Dennis Mannion from leading children's investment firm, the Children's Mutual suggests the closest alternative is an individual savings account (Isa), in which parents can save up to ?7,000 a year (?3,000 in cash) tax-free, and which they can informally earmark for children.

"The drawback, though, is that using up part of your Isa allowance for your child limits how much you can save tax-free yourself. And you cannot gift Isas to a child or set them up as a trust, which means there's always a danger you might dip into it in future years, or it could end up being fought over in a divorce case," he warns.

If you want your investment to be clearly set aside for the child, rather than just opening a deposit account, buying bonds or investing in some other way on the child's behalf, you have several options.

Most banks and building societies offer special cash accounts aimed at children and young people, and these can be in their own name from the age of seven, albeit normally with a parent as counter-signatory.

So long as the child's total income, including interest, is expected to be less than their personal allowance - expected to be ?4,895 from April - you can even arrange for them to get the interest on their savings without tax taken off, by completing form R85, available from the Inland Revenue or your local tax office. Some rates are competitive, for example Halifax's Monthly Saver Account is currently paying 5.5% gross.

National Savings & Investments products, such as the Children's Bonus Bond, provide another low-risk way of saving, albeit with unspectacular returns. The latest issue promises a 4.45% annual equivalent rate including five-year bonus.

For a more diversified investment, you could save up to ?300 a year tax-free with a friendly society, many of which offer savings products for children. The Children's Mutual's Youngster Bond Extra is a traditional with-profits endowment policy investing in a spread of cash, property, fixed interest and equity investments, and it features built-in 'smoothing' to minimise, for example, performance fluctuations.

The society claims that if you had saved the tax-free limit of ?25 a month for a child in such a plan from September 1989 to September 2004, he or she would have received 38% more than if the money had been in a building society.

But saving into investment trusts, unit trusts and open-ended investment companies offers the greatest long-term performance potential, says Anna Bowes of independent financial advisers Chase de Vere, who invests in shares-based funds for her two nieces.

"If you were to invest your child allowance every month, they could end up with a tidy sum," she says, although she adds that investing for children needs as much care as when investing for adults: "At the moment funds are advertising returns of up to 7% a year , but such quotes change over time and actual performance depends on a lot of factors. Check funds at least annually and be prepared to diversify into other holdings, especially in the later years."

To put investment funds in the child's name, you must 'designate' the account with their initials, meaning they are, in effect, held in trust for them until they reach 18, at which point they can transfer them into their own name. Take legal advice if you want to set up a more complicated trust, which might, for example, give you more control over who the money goes to and how it can be spent.

Bear in mind that parents are themselves liable for tax if more than ?100 a year in income accrues. You, or the child once the fund is transferred to his or her name, will also be liable for capital gains tax on profits from the sale of shares and other non-cash investments, although your financial adviser should be able to minimise any liability through the use of annual exemptions and reliefs.

Incidentally, leading fund management company Fidelity Investments has estimated that if you or your family and friends were to invest the full ?1,200 a year CTF allowance for 16 years from its launch this April, your child could, assuming an investment return of 6% a year, benefit from a lump sum of ?33,000 on his or her 18th birthday.

So if rich Aunt Agatha has read a CTF leaflet and is squirreling cash away for little Johnny, you'd better get saving for the older ones or there'll be hell to pay when he hits 18.

Useful links

· Child trust funds explains how the scheme works and provides links to approved providers.
· Inland Revenue
· National Savings
· Moneyfacts - features 'best buy' tables for children's savings accounts.