Parents who diligently put money away in savings accounts for their children wouldn’t expect to be hit with a tax bill, but a little-known rule means that taxman could take some of the interest from your child’s savings.

This tax rule means that once your child earns £100 or more in interest on their savings account or from investments that aren’t in an ISA, all of the income is taxed as though it’s the parent’s money. The intention is to stop parents from just funnelling their savings into accounts in their children’s names in a bid to avoid paying tax on it.

When interest rates were low, it would have taken a decent chunk of savings before you hit this £100 limit. But we’ve seen savings rates rise, including on children’s accounts, meaning you don’t have to have a fortune stashed away for your child before you hit the threshold.

HOW RISING RATES HAVE HAD AN IMPACT

For example, according to Moneyfacts the top children’s easy-access account pays 3.9%, which means that once you have more than £2,550 in there, you’ll hit that £100 limit. If you opt for a fixed-rate account you can earn even more, with the top two-year fixed rate kids account paying 4.4% (also according to Moneyfacts), so once savings reach £2,250 you’ll hit that £100 limit.

The rule also applies to any shares or investments gifted by a parent, that earn dividends each year and are not within an ISA. If the dividend level is above the £100 limit it will breach this rule and also be counted as the parent’s income.

If you reach the £100 mark then all of that interest (not just the interest over £100) is counted as though it’s the parent’s and will count towards their Personal Savings Allowance (PSA). The PSA means that basic-rate taxpayers can earn £1,000 in savings income before they pay tax on it, while higher-rate taxpayers have a £500 allowance. Additional-rate taxpayers have no allowance.

If your savings interest plus your child’s is still within your PSA then you’ll have no tax to pay. 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.

HOW CAN I AVOID THIS  RULE?

There are a few caveats that mean parents can avoid being hit with an unwanted tax bill if they are smart. First, the limit only applies to money given to the child by parents, any money belonging to grandparents, other family or friends which is paid into the accounts doesn’t count towards the limit. HMRC say that parents should keep hold of any evidence that payments have been made by other people, so they can prove it later should they need to.

But also the limit is £100 per parent, per child. This means parents should think carefully about how they gift money to their children. If each parent has an account in their own names, they should ensure they are making equal payments to their children, rather than one parent making all the transfers to their child’s savings account – as they could hit the tax limit far quicker. If they have a joint account the money will be assumed as coming 50:50 from each parent.

YOU COULD USE AN ISA

The other option is to use a Junior ISA or Junior SIPP as any money paid into an ISA is free from tax. You can pay in up to £9,000 per child each tax year into a Junior ISA and pick either a cash or investment ISA. A big difference between this and a normal child’s savings account is that the money will be locked up until the child turns 18 and can’t be withdrawn before then.

If this is a concern you could save the money in your own ISA, assuming you have some of the £20,000 annual limit remaining. This means you can access the money whenever you want (but it won’t be neatly ringfenced for your child).

How it works in practice

Mary and Martin have one child, Frank. If Martin transfers £3,000 into an account in Frank’s name paying 4% interest, he will earn £120 a year in interest. This will tip him over the £100 limit and means that all of the £120 interest will be counted as though it’s Martin’s. However, if Mary and Martin each transferred £1,500 into Frank’s account, still earning 4% interest, he would earn the same £120 a year interest, but as it’s from two parents only £60 interest is generated per parent, meaning they are not tipped over the £100 limit and no tax is due.

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