How to best invest for Children or Grandchildren?

Aug 28, 2019

Welcome to Finance and Fury, The Say What Wednesday Edition

This week's question comes from Cameron

"One small question we have been pondering. Our parents are gifting a small amount of money monthly to our 1yr old son (their grandchild). Rather than let in mature in a bank account we are interested in some sort of passive asx investment considering this could grow until he was at least 18. Any thoughts or commentary around this would be great to hear!"

 

Today – Talk about family investing options

– either for your kids or if grandparents are wanting to gift money to kids

 

There are a number of different considerations needing to be taken (mainly whose name the investments should be made in, along with the end purpose of the investments)

 

First - Funds for your Kids – What is the purpose?

1. Something they can access at 21 to put towards buying house, holding still, etc.

 

Considerations – Are the funds being invested or not?

1. No – Less to worry about
   1. Banks are happy to open accounts in kids names – take money from anyone
   2. Setting up any savings or investment accounts in your child's name for taxation purposes wouldn’t make a difference for quite some time.
   3. 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).

 

1. Yes – Normally the best option that people look for – the long term for kids/grandkids -
2. Which helps to grow the balance over the long term – Options – Either by grandparents or parents for kids
   1. Index funds, shares, managed funds or other types of investments.
      1. ASX listed funds or direct shares – brokerage costs on monthly transactions can eat up returns
      2. Managed funds/index funds have buy sells – provide more diversification and lower transactions costs
   2. education bonds (another ep), investment bonds,
3. Considerations with investing funds for minors
   1. The aim is to try and minimise any CGT or transfer costs upon your child turning 21
      1. any transfer of ownership of investments triggers a capital gains event (along with selling them),
      2. there are problems with setting any investments up in your child's name.
   2. You may also run into some issues with income tax rules 
      1. For those under 18 years old if it is deemed that the child is making the investment decisions. After earning above $416 (the 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%.
   3. 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 – but most companies expressly prohibit ownership by people under 18 for the same reason

 

Three options: General in nature – not taking into account your personal consideration

1. Investing by the grandparents as trustee
   1. 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 percent 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.
   2. 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 grandparents or parents
   1. 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
      1. With franking – can get away with little to no tax
      2. 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.
      3. Cons - capital gains tax will apply if the parent transfers the asset to the child at a later date.
      4. Hard to set up investments with you as the owner if you intend to gift – have to pay CGT/transfer costs
      5. Can be caught out with Trustee as well
         1. Know personally – bought first shares at 16 – under 18 – mum but me as account designation – Mum owner on my behalf
   2. Issues – Grandparents passing away
      1. Or Grandparents on Centrelink – Gifting rules or investing in their names will be asset tested
3. Investing in investment bonds
   1. Investment/insurance bonds are one of the simplest and most tax-effective investments
      1. Covered these in a previous episode
      2. 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.
   2. The ability to access the investment at any time in the first 10 years is a feature – but tax penalties apply
      1. 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
   3. Cons – Higher fees, 125% rule, Limited investment options
4. Investing in Education Bonds/Funds –
   1. Similar to Investment bonds – but have tax benefits if funds used for education purposes –
   2. Number of different kids can be added onto the one portfolio – number of people can be the owners –
      1. Parents and grandparents can contribute all into the one pool
   3. Tax benefit – internally – 30% tax paid – but this, when paid, goes towards a tax credit –
      1. If funds used for Education – this can be claimed back for education costs
      2. E.g. – Investment of $10k earns 10% = $1k taxable and $300 paid in tax – sits there as a credit to be claimed – claim $1k of education expenses and get the $300 back

 

Other Considerations:

1. 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.
   1. Investment bonds – limited but still viable when making a portfolio
   2. 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.
2. Normally when I look at these strategies – Education Bonds with a good range of index funds and managed funds works
   1. Can be withdrawn for non-educational expenses after 10 years tax-free – but you lose the Tax Credits
   2. Or use for educational funds along the way so kids don’t have HECS or can fund high school
   3. Monthly investing - managed funds can work well due to diversification and lower transaction costs
   4. General advice only obviously – but something to look into further

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

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