Personal Finance: Stocking fillers that won't give the taxman a Christmas bonus

For most children, Christmas means lots of presents, preferably toys and other treats. If - admittedly a big if - there is any cash left over, you can also build up capital toward the costs of your children's education or a first mortgage deposit. But, Iain Morse warns, try to avoid any unnecessary tax liabilities.

Surprising as it may seem at first sight, tax allowances on income and capital gains are the same for under-18s as for adults, with a couple of important exceptions. Children are not eligible for PEPs and Tessas. They can, however, use the basic personal allowance of pounds 3,765 before paying income tax, and the standard capital gains allowance of pounds 6,500.

That applies to interest and income from deposit accounts and investments unless these result from capital given by one or both parents. In that case, only the first pounds 100 of income can be taken tax free, with the remainder taxed at the parents' highest marginal rate. You can avoid some or all the pounds 100 limit on income from parental gifts by choosing low-yield investments which show capital growth.

Moreover, income from capital given by grandparents or other relatives is not subject to that surcharge. Ask them to contribute, although giving them the money to pay into your child's account in order to avoid tax is strictly illegal.

If you do want to give money to your children and are in danger of breaching the pounds 100 limit there is still a gap in tax law allowing avoidance of paying tax at the parents' highest rate.

That turns on putting capital into a "bare trust", where the trustee does not pay income to the child, or into a bank account in the child's name. Income arising is then treated as the child's own and subject to its allowances.

Another option is to invest into a roll-up fund, which does not generate taxable income. If partly or wholly cashed in after a child's 18th birthday, income and capital gains will be taxed as belonging to the child. That could be useful for those entering higher education and without much earned income.

So much for taxation. Most banks and building societies offer gross interest rates on children's savings accounts below 5 per cent. But the savings habit is one many parents want to encourage. You will need to give pounds 1,500 or more to breach the pounds 100 limit on tax-free income.

One of the best deals comes from Nationwide's offering, the Smart2Save instant access account, which pays 7.2 per cent annually on balances over pounds 1. On balances over pounds 500, Britannia comes top, paying 7.25 per cent on their First Saver Account. Many children's accounts offer incentives, free gifts, vouchers and the like. Sadly, none gives Teletubbies. You will just have to queue.

National Savings also offer five-year Children's Bonus bonds, the current issue paying a fixed rate of 6.75 per cent on balances between pounds 25 and pounds 1,000. Income is tax-free, and exempt from the pounds 100 limit. But early encashment is penalised.

Unit and investment trusts offer the prospects of long-term growth, and can be held on behalf of a child by a parent or trustee. Invesco markets a Rupert Fund, compete with soft toy or mug for new investors. Some 70 per cent of the fund is held in Footsie 100 shares. But performance has been poor; 71 per cent growth over five years against an 103 per cent average on UK equity growth funds.

Bryan Johnstone, of the stockbrokers Bell Lawrie, White, suggests that parents should look at "split level" investment trusts. These are funds, running between five to 10 years, where the income element from a share is split from the growth element.

Examples include Aberforth's Split Income trust, currently trading at a 21 per cent discount to the net value of its underlying assets. Mr Johnstone likes them because "they are passive investments, which can utilise a child's annual capital gains tax allowance even if the purchase capital comes from a parent".

Minimum investment limits on lump sum payments into in unit or investment trusts may deter many smaller savers. But monthly savings plans provide a flexible alternative. Foreign & Colonial will accept premiums of just pounds 25 per month and, once a plan starts, allow lump sum top-ups of just pounds 100.

Fund selection should balance risk and return against the likely timescale of investment. Remember, you hold these trusts on your child's behalf, and have effective control over when they are cashed until the child's 18th birthday.

UK equity growth and general funds are the most likely best buys, combining good 10-year returns with low volatility by comparison to international and emerging market funds.

But there are long-term alternatives which can serve your child a number of purposes in adult life. Friendly societies offer baby bonds; low premium saving plans with tax-free status. These run for between 10 and 25 years. Again, many offer poor returns.

Tunbridge Wells Equitable is an honourable exception, with growth on its with-profits fund averaging 11 per cent per year.

Better still, why not consider a full cost, whole-of-life policy from an insurer like Standard Life, the mutual insurer. The company will accept children aged from three months and a monthly premium of pounds 20. Over 50 years, in return for premiums invested of pounds 12,000, a policy of this type could have a surrender value of pounds 72,000.

This long-term approach has distinct advantages. Firstly, premiums are not inflation- linked but fixed at the outset. Maintaining the policy should not be difficult. Secondly, it can be used to back a mortgage, or be put in trust by your child for the benefit of your grandchildren. Finally, if you go with a mutual, and it converts to PLC status, windfalls may result.