Investing for children
One of the world’s leading investors and philanthropist, Warren Buffet once said "A very rich person should leave his kids enough to do anything, but not enough to do nothing”.
It’s only natural that every parent, regardless of their financial position, wants the best for their children. So if you’re in a position to invest money specifically for your children’s future, you should consider your options carefully – just as you would if you were investing for yourself.
All too often people make the mistake of heading into investments without exactly defining what they’re trying to achieve; so the first step is to clearly identify why you’re investing. The next step is to set a measurable goal and then implement a strategy that will achieve your goal while keeping in mind your personal circumstances, appetite for risk and investment time frame.
So for example, if you’re saving for your children’s tertiary education, figure out how much a university degree may cost, how much you need to regularly save and what investments are appropriate given your time horizon.
Sounds simple enough right? The real challenge is in determining which investment option most benefits you and your children and, more importantly, the relevant tax implications. This is where a financial adviser can really help.
The taxman taketh away
There are steep tax penalties on children’s investment earnings to discourage parents from hiding their income in their children’s accounts in order to avoid paying tax on their earnings.
These penalties mean that, for the current and next financial year, children under 18 can only earn $416 tax free. Any income in excess of $417 (and below $1,307) is taxed at 68 per cent (including the 2% temporary deficit levy), while investment income above $1,307 is taxed at 47 per cent.
These penalties mean that you should consider some more tax-effective options that you can take advantage of.
Investing for children can be a real minefield. Some of the more attractive investment options are complicated and are likely to be unfamiliar to you but the significant tax benefits make it well worth investigating further. Speak to us, your financial advisers, about the best option for you and your children.
Income from investment bonds, or insurance bonds as they’re sometimes known, is taxed at the corporate tax rate of 30 per cent rather than your marginal rate. The tax within the bond may also be further reduced as a result of franking credits and tax offsets, as well as other tax deductions from underlying investments. There’s no need to include anything (income or capital gain) on your tax return if your funds remain invested for 10 years. If they’re withdrawn before 10 years, tax rebates will apply, and after 10 years there’s no tax liability whatsoever on withdrawals.
There is a 125 per cent rule though. In the second and subsequent years of the investment period, you cannot invest more than 125 per cent of the previous year’s investment. If you do, you trigger a new ‘start date’ of the bond for tax purposes (the ten year time frame begins again).
Education savings plans
Education savings plan encourage regular savings and, similar to investment bonds, are taxed at the corporate tax rate of 30 per cent instead of your marginal tax rate. Most also allow you to claim a full credit for taxes paid if the investment is used for educational purposes. However, unlike investment bonds, education savings plans do not have a ten year or 125 per cent rule. You also don’t have to report earnings in your tax return while your investment remains in the savings plan. The catch is that these plans generally have high fees and may not allow you to withdraw your investment early, or if withdrawal is possible, it may trigger a penalty. So make sure you check the finer details.
Pay down the mortgage
If you have a mortgage with an offset account or redraw facility, you can ‘save’ for your children’s future by making extra mortgage repayments. Then simply redraw the extra payments you previously made to pay for things like your children’s education. This will reduce the principal owing on your home which will, in turn, reduce the interest that you pay. These additional payments cannot be taxed as no ‘earnings’ have been made even though the interest you save is a close substitute for earnings you may have received from a different investment option. And this method of saving is generally pretty flexible as you have access to your funds when you need them. You need to be disciplined though. Don’t go using your extra funds for other purposes like that holiday you ‘had to have’. Also make sure you check any fees you may need to pay for the privilege of having an offset account or redraw facility.