The best way to save for your children

Jan 9, 2019

Welcome to finance and fury, The Say What Wednesday edition, today we have a question from Mila:

Question

We are expecting our first child very very soon, so what is the best way to invest money for your children, apart from the obvious solution of having a dedicated savings account. Where can we get a better return and keeping in mind the different tax implications for having it in my name, my husband’s name, or the child’s bank account? We are looking to give it to them when they are 21.

Thank you,

Mila

Today we will explore those points:

Funds for your Kids

1. Gift: we will also do another episode on Education Funding itself. However, this episode is just looking at investing funds
2. Something they can access at 21 to put towards buying a house, holding still, etc.

The best solution would be heavily dependent on your situation

1. What are your marginal tax rates, mortgage payments, etc
2. What is the intended purpose of the funds will be at 21 (gifting, education, etc.)? 

Considerations:

1. Are the funds being invested or not?
2. If no, you have less to worry about
   • Savings accounts, and mortgage offset accounts are usually for a shorter term
   • Banks are happy to open accounts in kid’s names, as they take money from anyone
   • Setting up any savings or investment accounts in your child's name for taxation purposes wouldn’t make a difference for quite some time.
   • The ATO determine who needs to declare the income or gains by looking at who has 'control' over the account (i.e. if you are depositing/withdrawing money from the account, you would have to declare the income even if the account was in your child's name).
3. If yes, which options help to grow the balance over the long term
   • Index funds, shares, managed funds or other types of investments.
   • Education bonds (another ep), investment bonds,
4. Considerations with investing funds for minors
   • The aim is to try and minimise any CGT or transfer costs upon your child turning 21
     • Any transfer of ownership of investments triggers a capital gains event (along with selling them),
     • There are problems with setting any investments up in your child's name.
   • You may also run into some issues with income tax rules.
     • For those under 18 years old if it is deemed that the child is making the investment decisions. After earning above $416 (tax free threshold for non-exempt minor income), income is taxed at 66% until reaching $1,307, with all remaining income being taxed at 45%.

Whose name to invest in?

1. Unlike bank accounts, most fund managers refuse to accept direct applications from minors
2. Legal issues: share trust units fell in a market crash, the child could argue that he or she did not have the understanding to participate in this investment and ask for a refund.
3. Stockbrokers are generally prepared to buy shares in the names of children, and some companies expressly prohibit ownership by people under 18 for the same reason

Three options:

1. Investing by the parent as trustee
   • This is the most common strategy, but most people have no idea of the possible consequences of doing it. It does not get you around the punitive children's tax rates because the trustee will be assessed at 66% and there is a major difficulty in that the parent must at all times act as a bona fide trustee and not intermingle trust money with their own.
   • Example: in a leading tax case a couple accumulated a substantial sum in a trustee bank account and then withdrew it to buy a unit for the use of their children while they were at university. The parents decided to put the unit in their own name and not the children's name, the Tax Office successfully claimed the money was, in fact, the parents' money and assessed them for five years' back interest.
2. Investing directly by the parent
   • Invest in the name of the lowest-earning parent, i.e. earns less than $37,000 a year, the maximum rate of tax is 21% and all income
     • With franking credits, you can get away with little to no tax
     • It also reduces the possibility of the Tax Office disputing the ownership because parents are free to give money to their children whenever they wish.
     • The cons are capital gains tax will apply if the parent transfers the asset to the child at a later date.
     • Hard to set up investments with you as the owner if you intend to gift it, you have to pay CGT/transfer costs
     • Can be caught out with Trustee as well
       • Know the trustee personally, I bought first shares at 16, as I was under 18, my mum helped. I was the account designation, but mum was the owner on my behalf
3. Investing in investment bonds
   • Investment/insurance bonds are one of the simplest and most tax-effective investments
     • Covered these in a previous episode
     • All you have to do is make an investment into the bond and sit back and watch it grow. Then, after you have owned the bond for 10 years, you can withdraw all or part of the proceeds free of tax. However, there is no obligation to withdraw your money and you can leave it in the low tax bond area for as long as you wish.
   • The ability to access the investment at any time in the first 10 years is a feature. But, tax penalties do apply
     • The profits will be fully taxable, but you will be entitled to a 30% rebate to compensate for the tax already paid by the fund
   • The cons are: Higher fees, 125% rule, and limited investment options

Other Considerations:

1. Estate planning (i.e. wills, POA, etc) for the funds, as this can add a level of protection to the funds over the 21 years. This can be achieved without the need for a will in some cases, as investment/education bonds have these features inbuilt into them.
2. The final thing to consider is the investments themselves and the return you expect, versus the level of volatility (or speculative risk) of the investments.
   • Investment bonds are limited but still viable when making a portfolio
   • If you would be making regular investments, then trying to minimise transaction costs can be achieved through some well diversified index (or active) managed funds over the direct shares that they invest in.

Thanks again for the great question and speak to you soon.

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