Clients often ask us how to invest for their children’s future, especially with the cost of housing so unaffordable. But while investing for your child helps to set them up for a secure financial future and teaches them how to get their money working effectively for them, there are challenges with tax.
So what is the most effective way to invest for children and give them the best financial head start possible?
Should you invest in your child’s name or your name?
Unfortunately, there is no straightforward answer here. If you invest in your child’s name, they will generally pay tax at a high rate. If you invest in your name, you may incur capital gains tax when the assets are eventually transferred to your child.
There are things you can do to minimise the tax impact, such as holding the investments in trust, so it’s essential to do your due diligence on what’s right for your personal situation. We provide an overview of the different structures to invest in for your children below. A financial advisor can give you tailored financial advice on what is best for your family.
Structures to invest for children
Investing directly in your child’s name
When you invest for your child in your child’s name, your child will be the owner of the investment and have control over it.
The main downside of investing directly in your child’s name is tax. Once children get past a relatively low tax-free threshold, their tax rate becomes very steep – the ATO will tax unearned income exceeding $420 per year at a whopping 47 percent. This was put in place to limit parents from moving their money into their children’s accounts so that they could pay less tax themselves.
Investing in your name
When you invest for your child in your name, you will pay tax on the investment income at the marginal tax rate. If you’re part of a couple and one partner is on a lower income, it can be particularly tax effective to hold the investment in the lower income earning partner’s name. Investing for your child in your name also gives you the flexibility to choose when to transfer the investment to your child, which is not provided for in other structures. You can hold off transferring the investment to your child until you believe your child has the maturity to manage the money effectively.
The downside of investing for your child in your name is that capital gains tax will apply when you transfer the asset to your child. There is currently a 50 percent capital gains tax discount if the asset is held for more than 12 months, but this is subject to change based on the legislation and tax rates at the time of transferring the asset.
Investing as a trustee for your child
A popular option is to invest as a trustee for your child. The investment will be held in trust for your child in your name. That way, you pay tax on the investment income at the marginal tax rate, rather than your child. Again, if you’re part of a couple and one partner is on a lower income, it can be particularly effective to hold the investment in the lower income earning partner’s name. Another advantage of this structure is that the portfolio can be transferred into your child’s name without triggering capital gains tax when your child turns 18.
However a potential disadvantage of investing as a trustee for your child is that when your child turns 18 they become the legal owner of the investment and you lose all control. Some parents may feel that an 18-year-old will not have the maturity to manage the investment and will squander the money.
Investing in insurance bonds
A simple option to invest for your child is via insurance bonds. You hold and control the policy and nominate your child as the person insured. The child then takes over as owner at a preselected age (usually between 10 years and the mid-20s).
The big advantage of investing for your child through insurance bonds is that the bond is exempt from capital gains tax unless you sell before the preselected period elapses.
The downside of insurance bonds is that the management fees are generally higher relative to other investments, such as ETFs. It’s also not the best vehicle to teach children about money and investing, as there are strict rules around the amount of ongoing contributions you can make to the fund.
Investing in super
Depending on your and your child’s age, a creative way to minimise tax and retain control over the investment could be to set up a separate superannuation account under your name. For example, if you’re 40 years old and your child is 5 years, you’ll be able to start drawing on your super for your child when you’re at preservation age or 60 (and meet a condition of release), and your child will be 25.
Investing for your child through super is a tax effective option. Superannuation funds are taxed concessionally and money can be pulled out tax free, providing you are 60 and retired. This option also gives you complete control over the funds if your personal situation changes and you need the money to fund your own retirement.
The major limitation of investing for your child through super is that the money is locked in until you retire, so it might not be right for your situation if you’re a younger parent.
Let us help
Everyone has their own unique personal context when it comes investing and saving for the future of their children. The most effective way to invest for your child’s future will come down to your individual circumstances.
It’s important to consider the potential tax implications, as well as the level of control and flexibility you will have with each investment structure. An experienced financial advisor can help you understand the pros and cons of each structure and make a recommendation on the most effective option based on your family’s specific circumstances.
Contact one of Financial Spectrum’s financial planners today and learn how we can help you set your children up for a secure financial future.