Could you face an unexpected tax bill for interest earned on your children’s savings?

Most parents want to build a nest egg for their children’s future, if they can. You might want to help fund their education or contribute towards a deposit on a first home. 

But your good intentions could end up resulting in a hefty fee from the taxman - or a slap on the wrist if you fall foul of the rules.

A survey from investment firm AJ Bell revealed that only a fifth of parents understand how tax works for interest earned on their children’s savings accounts. Another fifth incorrectly believed that this interest was always tax-free.

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In fact, parents could be liable for tax as soon as their child starts earning £100 in savings interest. 

“Parents haven’t had to worry about this tax rule while savings rates have been abysmally low”, says Laura Suter, director of personal finance at AJ Bell. However, “now [that rates] are creeping up, they could find an unwelcome letter from HMRC landing on their doormat with a bill for unpaid tax”, she added.

We summarise the key rules you need to know to stay on the right side of the taxman, and share some top tips for how to reduce your tax bill.

Tax on child savings income: What are the rules? 

As soon as your child starts earning £100 in savings interest on money you have gifted them, it could become taxable. Importantly, it will immediately be treated as part of your personal savings allowance (PSA) - not your child’s. 

You won’t just be liable for any income over the £100 threshold either. You will be liable for all of it. 

“If your savings interest plus your child’s is still within your PSA then you’ll have no tax to pay”, explains Suter. “But if you’ve already used up the allowance (or your child’s savings tips you over), then you’ll have to pay tax on that money at your income tax rate.”

What is the personal savings allowance? 

The personal savings allowance is the amount of savings interest you are allowed to earn without paying tax. 

It varies depending on which tax threshold you are in, which is determined by your annual income:

• Basic rate: If you are a basic rate taxpayer (and have an annual income of up to £50,270), then your PSA will be £1,000 per year.
• Higher rate: If you are a higher rate taxpayer (and have an annual income of up to £125,140), then your PSA will be £500 per year.
• Additional rate: If you are an additional rate taxpayer (and have an annual income of over £125,140), then you won’t get a PSA. 

How to save for your child in a tax-efficient way

“It’s annoying that parents who have diligently saved for their children might find their good deed has a tax sting at the end of it”, says Suter. But the good news is that there are several ways in which you can reduce your tax bill. 

These include encouraging family and friends to gift too, perhaps as an alternative to a birthday present, and sharing the gift-giving between two parents. 

“The £100 limit only applies to money given to the child by parents”, explains Suter. Furthermore, it is “£100 per parent, per child”. 

Of course, you’ll need to keep track of this information so that you can prove it to the taxman, which can make things complicated. So, perhaps the best way to save for your child’s future in a tax-efficient manner is to open a Junior ISA.

What is a Junior ISA?

A Junior ISA is a tax-efficient wrapper that lets you to save and invest on behalf of your child, all without paying income or capital gains tax.

There are two types available - cash ISAs and stocks and shares ISAs.

Parents can put up to £9,000 into a Junior ISA each year. This allowance renews annually on 6 April, and belongs to the child. So the good news for parents is that it won’t eat into their £20,000 annual ISA allowance.

Best rates on cash Junior ISAs

Interest rates are currently high, so you can earn a decent amount by putting your child’s money into a cash Junior ISA. 

However, the Bank of England has held the base rate at 5.25% at the past four Monetary Policy Committee (MPC) meetings, and markets have already priced in cuts for later this year. 

As a result, savings rates have already dipped slightly from their peak - so you’ll need to act fast to make the most of higher interest while it lasts.

Considering a stocks and shares Junior ISA

If your child is still young, it might be worth considering a stocks and shares Junior ISA instead of a cash one. 

Cash is liquid, protected up to the value of £85,000, and free from stock market volatility. But it certainly isn’t risk free. When inflation is high, it can quickly erode the real value of your cash savings and any interest you are earning on them. 

Meanwhile, although stock markets can go down as well as up, they almost always outperform cash over the long run. 

For example, if we look back over the past five years, the average annual return of the MSCI World Index was 13.37%. This index tracks the performance of almost 1,500 large and medium-sized companies globally. 

Meanwhile, the most competitive interest rates available on cash Junior ISAs are currently around 4.95%, which is a significantly lower return. 

Eighteen years is a long investment horizon, and should leave plenty of time to iron out any bumps in the road when investing on behalf of your child. In fact, if you have anything longer than a five-year investment horizon, a stocks and shares ISA could be a good option to consider.