Future generations are going to need all the financial assistance they can get as government financial support for education, home ownership and retirement looks set to become just a bitter sweet memory.
We sought advice from financial planners concerning the Dos and Don’ts of when, how and why to invest for children.
Why consider children’s investment vehicles?
The most commonly expressed reason that parents give for wanting to establish an investment strategy for their children is education – in order of priority, private secondary schooling, private primary schooling and tertiary education.
Other motivating factors include saving a deposit for a child’s first home, buying a first car, funding an overseas trip and starting a super fund.
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“The purpose and timeline determines the strategy,” says Jeremy Gillman-Wells, principal advisor Bentham Financial Group and an authorized representative of AMP financial planning.
“If you want to pay for orthodontic work in three years time cash is the best strategy. But if you want to save for a child’s house or education that’s at least 10 years away assets that will provide capital growth as well as income are what you’d be more likely to target; that could be shares or managed investments and then you’d want to look at doing it in the structure that’s appropriate, which is either directly or through an insurance bond.”
Potential methods and strategies
The method favoured for short-term goals is good old-fashioned cash placed in a high yielding internet based bank account.
“Find a no-frills account where you’re paid a fairly high rate of interest and the money is at call,” says Gillman-Wells. “Often at-call money in an online account provides a better rate than a term deposit without the money being locked away.”
His suggestion is to get an account that is fee-free, offers unlimited transactions and pays interest on a monthly basis “because that gives you better opportunity for compounding and therefore a better long-term result”.
For long-term investment for children’s needs Marisa Broome, of Wealth Advice tends to use a regular investment plan through a managed fund rather than the traditional tax-paid insurance and friendly society bonds, traditionally regarded as the optimal method to invest for children. The reason for this is that the investment options via a managed fund are broader.
Neither Gillman-Wells nor Broome are partial to insurance bonds, friendly society bonds or scholarship funds due to their restrictive conditions.
Gillman-Wells admits however that while he is not a big fan of utilising insurance bonds (for the reasons highlighted below) they do suit investors who are earning over $150,000 per annum and cop a tax rate of 45% because investment in insurance bonds reduces it to 30%.
Sue Dahn, Principal Adviser, Pitcher Partners Investment Services suggests grandparents between the age of 60 and 65 consider using their superannuation funds as investment vehicles for grandchildren.
She says, “at age 60 you can turn your super fund into pension mode and reduce the tax to zero percent. Funds can be contributed to super funds with the mental designation of the children’s purposes and the generated income can then be drawn on some time in the future all at zero tax rate”.
The qualification she says is that “super contributions cannot explicitly be for children’s benefits, they must be consistent with the sole intention of being for the retirement purpose of members”.
Traps: Beware of the sting in the tail
“A lot of people think that insurance bonds are tax free because they’ve heard that after 10 years all the proceeds you withdraw are tax free and that there is no capital gains tax to pay,” says Gillman-Wells.
“But all the way along the company tax rate of 30% applies internally to that bond. So although the person isn’t paying that tax directly themselves it is still a tax paid investment internally.”
Gillman-Wells’ main anti-insurance bonds argument relates to the 125% rule, which allows an investment of 125% per annum of the previous year’s sum. What a lot of people are unaware of, he says, is that once you commit to this 125% an inability to meet a monthly payment means the maximum you are able to invest the following year is reduced accordingly. The exception is if a contract is entered into that stipulates a set monthly amount. This enables you to catch up with premiums missed.
The other trap, says Gillman-Wells, is that if you invest more than 125% over a year you restart a new ten-year period.
“If you pull out your insurance bond anywhere up to the eighth year all of the profit is assessable as taxable income, during the ninth year two thirds of the profit is assessable, during the tenth year one third is assessable, although a 30% rebate does apply for tax already paid. It’s only after the tenth year that all the profit is tax paid,” he says. The other point to note is that there is no CGT discounts because the tax is paid by a life office,” he says.
Regarding scholarship funds such as the Australian Scholarships Group, Dahn warns that if you fail to use it for the purpose specified you forfeit any investment earnings.
Investing in your name versus your child’s name
The consensus is that apart from certain circumstances such as the desire to teach children how to be responsible with money, investing in the name of the lowest income-earning parent is the most tax effective.
“The system is not set up to encourage the earning of investment income in children’s names. The idea being to dissuade people from putting income in their children’s names in order to avoid tax,” says Dahn.
“When a child is under 18 a very punitive tax structure applies. Children pay 46.5% on every dollar earned above $1667. Whereas adults can earn $6000 tax free and on the next dollar pay only 15% tax.”
A bare trust arrangement, where the parent invests in the child’s name in the form of a trust and assumes a trustee responsibility, the child tax rate applies; the exception being in the case of a deceased estate.
Children’s savings accounts, which are now offered by almost all lending institutions, are in essence just brand building schemes designed to bring people in the door. They are low interest but Gillman-Wells, Broome and Dahn caution that there are many terms, conditions and limitations on the amount held in them and added every month.
The alternative ‘Upside-Down’ plan
Dahn suggests that ultimately the best approach is to look at the issue of children’s future financial needs from an “upside-down” perspective and work out the best way to reduce future expenditure, which in many cases comes down to reducing the mortgage.
Both Dahn and Gillman-Wells believe that allocating the amount targeted for children’s future needs and putting it into the mortgage is the simplest, most tax-effective and risk-free approach.
“Put together a funding plan for how much the education or whatever it is you want to save for is going to cost, work out how much you’d like to contribute each fortnight or month, keep a little spreadsheet or some sort of record of what that would amount to if you were getting bank interest and put it into your mortgage,” says Gillman-Wells.
“The big interest damage on a mortgage is done in the first five to ten years, where your principal is high and your interest bills are huge. So the faster you can get that part down the better off you’ll be and in ten years’ time if you have to draw that up by $20,000 for your kids the impact is so much less.
“At the moment the current interest rate for a mortgage is 8.5%-9%, and if the best bank account is offering 7.5% my question to clients is: what would you rather get, a guaranteed return of 9% in your mortgage, or put it in your bank, get a 7% return and then have it taxed?”