Give your kids a £10,000 nest egg

Find out how to give your kids a nest egg of almost £10,000 on their 18th birthday - without it costing you a fortune!

A university education, saving for a first home, taking a gap year or getting married. These are all things your kids might want to do when they get older. But the question is: how will they ever afford them?

This is where child trust funds (CTFs) come in. These accounts are designed to give your kids a helping hand with their savings. Here's how they work:

Child trust funds: the basics

Think of child trust funds (CTFs) as a kind of ISA for kids.

CTFs were launched in April 2005 to encourage parents to save for their children's future. If your child was born on or after 1 September 2002, you are entitled to receive a CTF voucher from the Government when you register for Child Benefit. The voucher is worth £250 - or £500 for lower income families.

A second top-up of the same amount will be paid on the child's seventh birthday. Parents, relatives and friends can also top-up the CTF up to a maximum of £1,200 in total every year.

This money can then be saved or invested tax-free until it matures when the child reaches 18.

Types of CTF

Sounds simple enough, but there's more than one type of CTF. They fall into three categories: cash, stakeholder and shares. Let's take a look at each one in turn:

Cash CTF

This is very similar to a cash ISA where you can put money aside for your kids, and earn interest tax-free. The rate earned is usually variable, so it's a good idea to check the CTF stays competitive from time to time. If the rate begins to fall behind, you can switch it to a better CTF whenever you like.

Get a free guide on investing for children

Stakeholder CTF

A stakeholder CTF invests in a range of shares in an investment fund, rather than cash. Again, all returns are tax-free.

To qualify as a stakeholder account, the CTF must follow certain rules:

• The charges on the fund must be capped at 1.5%.
• The CTF must accept contributions as low as £10.
• Contributions must be invested in a wide range of company shares to spread risk.
• When the child is 13, money is gradually moved into lower-risk investments. By the time the CTF matures, it will be held entirely in cash. The idea is that the value will be protected from a stock market collapse in the five years running up to the child's 18th birthday, because at this point, the child may wish to access the money.

Get a free guide on Stakeholder CTFs

Shares CTF

A shares CTF also invests in the stock market, but without all the rules attached to the stakeholder version. This means, the CTF manager can take far greater risks when investing in funds, with the aim of maximising returns.

Get a free guide on Shares CTFs

How should you invest your child's voucher?

This really depends on how much risk you want to take with your child's savings.

A cash CTF will provide a secure home for your child's savings. In the four years since launch, they have generated an average return of more than 24%**. That said, in the current low interest rate environment, returns are set to drop back this year. Many cash CTFs are now only paying around 2% to 3%, which will have a significant impact on overall growth this year.

But even if interest rates were higher, I don't think that cash is the best place for your child's savings. The effects of inflation over an 18-year period will erode the value of your returns. And, historically, shares have always performed better than cash over the long-term.

Think stakeholder

Unless you're really risk averse, I would suggest you consider being more adventurous. A stakeholder CTF will give you plenty of exposure to the stock market, but there's a downside: volatility. While there's potential for better growth than a cash CTF can produce, the value of a stakeholder plan can drop off dramatically if the stock market collapses.

For example, in the first year following the launch of CTFs, the average stakeholder fund returned a fantastic 24%, far outstripping the 5% return produced by cash CTFs over the same period. But, in stark contrast, stakeholder funds dropped more than 26% of their value in the last 12 months to April 2009. And so, since their launch, the average return is a very disappointing -7%.

But that's the nature of the stock market, and there's no question shares have endured a very bumpy ride in the economic downturn. That said, I still believe it's the best place to be over the long-term. More encouragingly, stakeholders are already up 8% this tax year on the back of stronger market performance. So, you can see how quickly things can change.

Want better returns?

If you want to take even more risk with the potential for greater reward, some shares CTFs are even more speculative. You could invest directly in shares in the UK and globally, for example. But, the more risk you take, the more volatile the investment could be. The charges may also be higher than a stakeholder, so watch out for that too.

Don't forget, whichever CTF you choose, if you're not happy with it, you always have the option to transfer it to a new plan.

How to make the most of CTFs

This is really simple. Top it up whenever you can. Get your kids' grandparents and other relatives to do the same. But don't worry if you can't save a lot. On average, CTFs are topped up by £24 a month*, but even this relatively small regular amount could grow to £9,750*** by the time it matures.

What's more, if you can afford to save the maximum yearly contribution of £1,200, the plan could potentially be worth a whopping £37,000!

I think any child will sincerely thank you for a fantastic financial headstart like that when they reach 18.

Get free financial guides on investing for your child

* This is the amount contributed into CTFs run by leading provider, The Children's Mutual.

** Source: Investment, Life & Pensions Moneyfacts for cash and stakeholder CTFs returns.

*** Source: The Children's Mutual. Assumes the fund grows by 7% a year in a stakeholder CTF which charges 1.5% a year.

More: 10 things to know about child trust funds | Are child trust funds worth investing in?