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Avoid the University of Financial Strife

When the Labour government launched Child Trust Funds (CTFs) in January 2005, one of the aims of the investment vehicle was to help make higher education economically viable for a larger proportion of the population. But with the coalition government scrapping CTFs from January next year, what are the options for those wanting put away a university savings pot for their children?

First port of call

Darius McDermott, managing director of Chelsea Financial Services, says one of the first options would be to use your individual savings account (Isa) allowance to invest in equities or collective investment funds, as any income or capital gains would be tax-free.

However, one of the drawbacks is that you can't segregate accounts if you are saving for more than one child and there are tax implications once you reach your annual Isa limit.

Danny Cox, head of advice at Hargreaves Lansdown, says there are ways of negating the tax liabilities that both an Isa and a CTF avoid, typically by creating a bare trust.

He explains: "At age 18 when the child hits majority age the account automatically transfers to them. Then the income tax and capital gains tax - any tax liability, is chargeable on the child rather than the person who has set the trust up in the first place."

This is particularly beneficial to parents who fall into a higher tax bracket.

Mr Cox adds: "If you are looking at relatively modest amounts, say £1,000 a year, it can work out to have no worse tax treatment than a CTF."

Investment choice

Another benefit of a bare trust is that it gives the parent a wider choice, and better investment opportunities than a CTF. "You can effectively invest in any unit trust or Oeic (Open-ended investment company) on that basis and choose whichever fund or fund manager you want to invest in," explains Mr Cox.

If you are looking to build up a pot over a long period of time, in this case typically between 15 and 20 years, then higher risk investments, such as equities, are usually your first port of call.

"The key decision is when the money is going to come out," says Mr Cox. "Certainly, if you are investing for 10 years or more you would be happier to look at smaller companies and emerging markets."

Mr McDermott agrees. "Clearly you can afford to take a much greater risk, because you have a much longer period to see out market volatility. I would be looking to the emerging markets in Asia, parts of the world that are visibly growing and where I expect the currencies to strengthen versus sterling over time."

However if you are aiming for a pot of £35,000 or more, you would have to allow for the high yields created towards the end of the investment period.

Risk management

If you set up an investment for your child and the income is greater than a £100 per parent per year you will be carrying the tax burden, which could call for an alternative strategy.

As well as having a simple bare trust one option is creating a trust fund, effectively having a separate trust from within which you can invest the money.

Another strategy would be to look at Zero Dividend Preference (ZDP) shares which are subject to capital gains tax, rather than income tax which is subject to a higher tax band.

But James Norton, director of Evolve Financial Planning, warns that while ZDPs are a good option, you have to understand them, and you need to understand the risks.

Similarly, while a long-term equity investment of up to 20 years does reduce the impact of short term volatility, investors do need to be aware of the charges that could be incurred over that period of time. As such, opting for a low cost tracker could be a lot more economical than an actively-managed fund.

"A tracker or ETF will need less maintenance, it will be a lot cheaper and because it's cheaper chance are it will outperform 60-70 per cent of actively-managed funds. We would advise a very broad index strategy so something like an MSCI global equity tracker where it's given the diversification of global stock markets. You would probably be paying 0.3 to 0.4 per cent per annum whereas with a unit trust you will be forking out around 1.5 per cent plus. And if it is a fund of funds you would be paying around 2 per cent," argues Mr Norton.

It is also important to ratchet down the risk in order to protect the capital in the remaining few years of the investment. Mr Norton recommends national savings as a good starting point for low-risk investment. "You do not want to be in stock market linked investments six months before you need the money, there's always the risk the market could drop 50 per cent," he says.

Mr Cox adds that if the time frame left before your child enters university is under five years you should be asking whether you want to be taking any capital risk at all. "Now, you should be looking at gilt or cash returns, and moving into the money markets or gilt funds or even just a gilt itself," he adds.

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By David Pawsey,
06 July 2010

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