It is in a parent’s nature to want to do all they can to help their children succeed in life. Part of this desire, is to help them succeed financially and this leads a lot of parents to wonder – how can I invest on behalf of my children?
There are lots of ways you can tackle this, and each strategy has its own set of pros and cons. But before we get into the nitty gritty, I just want to preface this by saying that investing for children is great thing to do provided you have the means. In other words, investing for your kids is a luxury item.
One of the leading causes of marriage break downs and family problems is money issues. I personally think that the best thing you can do for your kid is to give them a happy, healthy, and supportive home life every day and it is very hard to do that if you have significant financial stress in your life.
So sometimes the best thing to do is to focus on building your own net worth! Whether that be through debt reduction, boosting your super, building an emergency fund or whatever else, because the kids will benefit indirectly from that. And if they are lucky, they might eventually get a piece of the pie through an inheritance.
So, with that said, let us assume you are in a position to invest for your kids, and investigate how you might go about doing so.
Investing in the child’s name
Typically, it is not a good idea to hold investments directly in the name of a child under the age of 18. This is simply because of tax. They can only earn $416 per financial year tax-free and if they exceed this, hefty tax rates as high as 66% may incur.
These scary tax rates for minors exist to stop wealthy people holding assets in their children’s names to avoid tax.
There are certain income sources that are excepted from these high tax rates which include income generated from the proceeds of an inheritance and earned income, or if the child has a disability then they are considered an excepted person.
But in general, it is not a good idea to hold assets directly in a child’s name due to the harsh tax rates, unless it is just a little bit of cash in a savings account. It is also very hard, if not impossible, to buy growth assets, like shares, directly in the name of a minor.
Investing in your own name
If it is not practical to invest directly in the name of the child, how about investing in your own name and then just gifting the assets later? Well, this is one way of doing it and it can work for some people.
Generally, if you are going to implement this strategy you want to have a spouse that has a low marginal tax rate. Or in other words, a spouse with a low taxable income. This is because any investment earnings will be taxed in the name of the owner.
The benefit of this is that an adult is subject to the standard marginal tax rates as opposed to minor tax rates. Also, your options of what you can invest in are just about limitless. This makes it easy to invest in growth assets like shares and exchange-traded funds (ETFs).
The downside of investing in your own name is that when you gift the asset to your child the ownership changes, which in-turn triggers a capital gains tax (CGT) event. This means that without proper tax planning, you could end up with a big tax big upon gifting the asset to your child, particularly if you have been investing over the long term. There are ways to potentially mitigate the tax liability, but this is a discussion for a future date.
Informal Trusts
Investing via an informal trust is very similar to investing in your own name but with a twist. Instead owning the asset in your name, you own the asset in your name “as trustee for” the child.
The benefit of this approach is that when the child turns 18 you can typically transfer the ownership of the shares to the child and not trigger a CGT event. Instead, the child will inherit the original cost base.
This is possible as the ATO considers who is the beneficial owner for CGT purposes. Under an informal trust the beneficial owner is, and always has been, the child as the assets have been owned “as trustee for”.
There are several different online broker accounts and managed funds that will allow you to own assets under an informal trust. This makes your investment options under an informal trust very flexible.
One thing to bear in mind is that if the asset that you are investing in produces income, the income will still be taxed in the parent’s name at their marginal tax rate. So again, it is best to invest via an informal trust in the name of the parent with the lowest taxable income.
Investment / Insurance Bonds.
The term investment bond or insurance bond can be used interchangeably – potato / potahto – and I am a big fan of this structure of investing under the right circumstances. But unfortunately, a lot of people don’t understand investment bonds very well.
Think of an investment bond a bit like a super fund – it is a separate structure with its own set of rules.
Investment bonds have a flat tax rate of 30%. This means that all income and capital gains made within the bond are taxed at 30%. So instantly, you can see this will be beneficial if both parents marginal tax rates are above 30%.
Investment bonds are a “tax-paid” investment which means that all income and capital gains are taxed within the bond. This is great because when it comes to lodging your personal tax return there is nothing you need to declare, it has all been accounted for inside the bond. From a simplicity perspective, this makes investment bonds very attractive.
The real kicker of investment bonds come from when you hold them for the long-term. If you hold the investment bond for 10+ years, your investment becomes 100% CGT free. This is a massive benefit for those looking to invest for the long term.
Although its beneficial to hold your investment bond for the long-term, you can access it any time. There are no restrictions to accessing the money and, if you did, you would be eligible for a 30% tax offset for any tax already paid within the fund.
Before entering into an investment bond, there are some factors that you need to consider including:
- There is a 125% rule on contributions. That is, you can only contribute up to 125% of what you contributed in the previous year;
- If you don’t contribute anything in a given year, the bond will be closed to further contributions (125% of $0 is $0);
- There are limited investment options available through investment bonds. You are limited to the options provided by the bond issuer; and
- Fees can be high through some of the investment bonds out there.
Typically, the investment bond will be held in the parents’ name, but some bond providers will allow you to transfer the ownership to the child at a nominated vesting age. There are a number of different bond providers out there so do your research and find one with suitable investments and relatively low fees.
Discretionary family trust
When you setup a family trust, you act as trustee. This could be yourself as an individual trustee or as a director of a corporate trustee. The assets are owned by you as trustee for the family trust.
Of all the structures available, a discretionary family trust is the most flexible from a tax and investment perspective. That’s because you have the option to invest in any asset class you like via the trust and investment returns are distributed at the trustee’s discretion.
Each financial year, income and capital gains are distributed to the beneficiaries of the trust at the trustee’s discretion. Under a discretionary family trust, beneficiaries generally include any family member or companies and other trusts run by family members. This gives you the ability to distribute income differently each year dependent on your family members marginal tax rates.
When you build up assets in a family trust for the purpose of gifting those assets to your children, you can distribute out the assets as you see fit. You could do it in a single year, over multiple years or even set them up a regular income stream from the trust.
The assets can be either sold down by the trust, with the cash distributed to your children, or you can transfer out the asset via an in-specie transfer. Both actions will trigger a CGT event.
The downside of family trusts is that they can be expensive to setup and expensive to operate as you will need to do an annual tax return for the trust each financial year. Given this, family trusts are not recommended unless you have some pretty decent assets to invest. I would suggest a minimum of $100,000 before you even consider it.
If you do decide to go down the family trust route, I would highly recommend you seek professional advice first as this can be a complicated arrangement which you do not want to get wrong!
Superannuation
This strategy was bought to my attention by a good friend of mine, who is also a Financial Adviser, and is potentially more hypothetical than practical but I thought it was an interesting one to throw into the mix. That is, investing for your children via a super fund.
It is no secret that in Australia, superannuation is generally the most tax effective structure we have for investing as a super fund has its own tax rate of 15%, which is typically a lot lower than the average person’s marginal tax rate. So why not establish a super fund for your child and invest via super?
Well, there are obvious downsides to this strategy and the most glaringly obvious one is that your child would need to meet a condition of release before they can access the funds. Typically, this has always been retirement, and the maximum preservation age for retirement is currently 60, but who knows what it will be in 30+ years’ time. However, purchasing their first house may also meet a condition of release.
Under the first home super saver scheme, you can make voluntary contributions to super of up to $15,000 per financial year and $30,000 in total and use those contributions as a deposit on your first home. I am not going to go into the full details of this scheme now, but I did do a blog on it previously if you are interested.
This would mean that if your intention is to help your kids out with buying their first house, this may be a potential strategy to do that. However, consideration should be made as to whether it is beneficial for your kids to use the scheme themselves when they are working to save tax rather than the gifted funds taking up the allowable limit.
But let’s say you don’t want to help your kids buy their first house, you want to set them up for the long term. Well, this could also be a great strategy for helping your kids retire comfortably one day.
If you invested $10,000 in a super fund for a 15-year-old child, and you could earn 6% p.a. on the money after fees and taxes, then by the time your child reaches age 60 that $10,000 could be worth approximately $148,000. Add some regular contributions on top of that, from when your child starts working, and it can see them sitting pretty in their retirement.
As you can see, theoretically, using super can have some pretty good benefits but there are a huge number of considerations to make before going down this path. Legislative changes, access to benefits, the transfer balance cap, the ability to actually open a super fund for a minor – these are just a few of the considerations that need to be made before going down this path.
Personally, I don’t think I would use this strategy as the time horizon is too long and too much can change in that time.
Final thoughts
Before investing any money for your kids, the three primary considerations you need to make are – how long will you be investing for, what do you want to invest in, and what will be the tax consequences. If you do decide to start investing, get your kids involved so they can learn how assets behave and build good financial habits to take with them throughout life.
