All parents want their child or grandchild to have the best possible start in life. Planning for a child’s future will go hand in hand with the parents’ financial goals. In this article I will explore the various options available and key considerations when it comes to investing for children.
Background
When making a decision in relation to the appropriate ways to invest for a child or grandchild, it is important to consider:
- the purpose of the investment and the investment time horizon
- the acceptable level of risk
- ongoing taxation of any income derived, including any future capital gains tax
- when access to the cash or other assets is intended to occur, and
- desired level of ongoing control over the money and the need to ‘protect’ the funds.
Investing in the child’s name
It is typically a bad idea to invest in the name of a child under the age of 18 unless it is just a little bit of cash in a savings account. This is because minors attract hefty tax rates as high as 66% on any unearned¹ income above $416. These penalty child tax rates are designed to deter parents from sheltering income in their child’s name to avoid tax.
| Other Income | Child Tax Rates |
| $0 – $416 | Nil |
| $417 – $1,307 | Nil + $66% of the excess over $416 |
| Over $1,307 | 45% of the total amount of income that is not excepted income² |
²excepted income is employment or business income from child’s own exertion. It also includes income from inheritance or lottery winnings. A child with a disability is also excepted.
Investing in your own name
Another option is to simply invest in your (parents) own name while allocating it in your own mind as being for the eventual benefit of the child. This strategy is most effective when the lower income-earning spouse holds the investment in their name, as investment earnings will be taxed at their lower marginal tax rate.
This option is preferable to investing in the minor’s name because it allows the parent to impose terms and conditions on the investment. You don’t automatically have to give the child the money at 18. Also, the situation where penalty rates apply is removed, which can be exceptionally punitive.
| Other Income | Adult Tax Rates |
| $0 – $18,200 | Nil |
| $18,200 – $45,000 | 19c for each $1 over $18,200 |
| $45,000 – $120,00 | $5,092 plus 32.5c for each $1 over $45,000 |
| $120,000 – $180,000 | $29,467 plus 37c for each $1 over $120,000 |
| Over $180,000 | $51,667 plus 45c for each $1 over $180,000 |
Advantages
- Income is taxed at adult marginal tax rates, rather than the Minor’s penalty tax rates.
- As the parent, you retain full control over when you gift it (like age 25 or 30), since you are both the legal and beneficial owner. You can also stipulate conditions on the gift, such that it can be used for a home deposit or higher education expenses.
Disadvantages
- Transferring (gifting) the asset to the minor will result in capital gains tax (CGT) liability, as it represents a change in beneficial ownership.
- The parent must declare any income from the asset in their assessable income, even though they may not enjoy the benefit of this income.
Investment (Insurance) Bonds
An investment bond is a managed investment, usually operated by an insurance company or friendly society. Investment bonds offer a broad range of investment options such as cash, fixed interest, shares, property, or a range of diversified investment options. The value of each investor’s bond rises or falls with the performance of the underlying investments.
They are known as a ‘tax paid’ investment because earnings from the bond are taxed internally by the life company at the rate of 30%. Because of this they are considered a ‘set and forget’ type of investment, as the earnings do not need to be included in your personal tax returns.
How it works
- The life insurance company pays tax on earnings within the bond and, after 10 years, you are able to withdraw the value of the bond with no further tax payable.
- Withdrawals can be made from an insurance bond at any time, however you may be liable to pay some tax if a withdrawal is made within 10 years from commencement of the insurance bond.
- You can make additional contributions into the bond at any time and up to an amount equivalent to 125% of the total contributed in the previous year, without the need to commence a new investment.
- Ownership can be changed via assignment. Where done as a gift, it should not create a personal tax consequence for the original investor(s) and subsequent owner(s).
- Upon your death, the balance of your account is paid to the nominated beneficiary or your estate with no tax implications.
Tax offset
If you make a withdrawal within the 10 year period a portion of the investment growth is included in your assessable income as shown in the table below:
| Withdrawal | Amount of growth included in tax return |
| Within 8 years | Full amount |
| Between 8 and 9 years | Two-thirds |
| Between 9 and 10 years | One-third |
You are then entitled to a 30% tax offset on this assessable portion to allow for the tax already paid by the life insurance company. This offset helps to reduce your tax payable on taxable income but cannot be used to pay the Medicare levy or be refunded as cash.
This means:
- If your marginal tax rate is higher than 30%, you will generally benefit from holding the bond for the full 10 years before making a withdrawal to maximise the lower tax rate.
- If your marginal tax rate is lower than 30%, you could benefit by withdrawing some or all of the bond before 10 years and receive a tax offset that can reduce tax on your other income.
Additional contributions and the 125% rule
Investment bonds provide flexibility for you to make additional contributions at any time, but it is important to note that if your contributions in any year are more than 125% of the previous year’s contribution, this will restart the commencement date under the 10 year rule.
For example, if you make a contribution of $1,000 in one year, the 10 year period will recommence if the next year’s contribution is more than $1,250.
Estate Planning Benefits
An investment bond is a life policy. The death of the life insured will trigger the payment of bond either to the nominated beneficiary or to the policy owner if no beneficiary is nominated. If the life insured is the policy owner, the balance will be paid to their estate. Any amount received as a result of the death of the life insured is completely tax-free, irrespective of the 10 year rule.
Informal Trust
Investing through an informal trust is akin to investing in your own name, with the distinction that you hold the asset in your name “as trustee for” the child.
Many brokers offer the option to open a minor trust account, with the parent as the trustee and the child as the beneficial owner, enabling a seamless transfer of ownership to the child at age 18 without triggering a CGT event. Instead, the child will inherit the original cost base.
Tax Treatment: whose money is it?
The ATO will consider all the facts surrounding the investment in deciding who is responsible for paying tax on that investment: the parent or the child.
Taxed in child’s tax return
- Where the money comes from the parent and it is a bona fide gift, the money is deemed as the child’s. The gift may have a wish, or a purpose attached to it, which is distinct from the gift being conditional. Most gifts will have some sort of purpose, such as being used to help the child to buy their first car.
- Gifts that have a wish or a purpose will still be treated as if the money were the child’s and taxed in the child’s return.
Taxed in parent’s tax return
- Where the parent is seen as applying or intending to apply, the money for their own use, the investment will be deemed as the parent’s and taxed in their tax return at their marginal tax rate (MTR).
- If the gift to the child is conditional, the investment is deemed to be the parent’s and taxed in their tax return at their MTR. For example, where the child will receive the investment on reaching age 18 provided they attend university. If the child does not attend university, the money is redeemed by the parent and used as if it belonged to the parent.
Advantages
- No CGT is triggered when you transfer the ownership of the asset to the child when they turn 18.
- Income is taxed at adult marginal tax rates, rather than the Minor’s penalty tax rates.
- Having a dedicated account for a minor could prevent you from spending it.
Disadvantages
- A key disadvantage is that the parent loses control over the funds. When the child turns 18, they have legal ownership of the asset and can do whatever they want with it.
- If it is genuine gift to the child with no conditions attached, then the income from the asset is taxed at the Minor’s penalty tax rates.
- The cost or hassle to do a tax return for the minor each year.
Formal (Discretionary Family) Trust
Of all the structures available, a discretionary family trust is the most flexible from a tax and investment perspective. However, this involves significant establish and ongoing costs.
Trusts don’t pay tax, so each financial year income and capital gains can be distributed to the Trusts beneficiaries at the trustee’s (parents) discretion. Beneficiaries include any family member (including children) as well as companies or other trusts managed by family members.
Discretionary trusts provide flexibility, as you can distribute investment income as you see fit.
Advantages
- Distribute investment income in a tax-efficient manner, as per the trustee’s wishes.
- The trustee (parent) has full control over when income and assets are gifted.
Disadvantages
- The expenses associated with establishing and managing a discretionary trust are significant, necessitating a larger initial investment to make this structure economically viable. A minimum investment of $100,000 is typically required.
- An annual tax return for the trust and also the beneficiary is required.
Mortgage Offset Account
Rather than using a standalone cash account to invest for a child, another option may be for parents to make additional mortgage repayments and redraw the money when required. Alternatively, they could deposit additional money to the offset account attached to their mortgage.
Both these methods generate interest savings and may enable the home loan to be paid off earlier while still providing access to those funds for child or other expenses.
Advantages
- a risk-free and tax-free investment return equivalent to the home loan interest rate, and
- low or nil fees are payable, although some lenders do charge a fee for redraws.
Disadvantages
- there is no account balance to keep track of, unless a separate offset account is established for this purpose.
- unlike other options, the return isn’t credited to the account but is reflected in the interest savings.
- more discipline is usually required to ensure the money is not accessed for other purposes.
Superannuation
In some circumstances superannuation may be a valid savings option for children, depending on their needs and objectives.
Advantages
The main advantage associated with this strategy is earnings are taxed at a maximum rate of 15%. All contributions made by parents or the child are usually non-concessional contributions (NCCs) and limited by the NCC cap.
Disadvantages
The main disadvantage of super is that capital cannot be accessed until a condition of release is met. Locking up the funds for around 50 to 60-plus years is unappealing for most people, irrespective of the potential tax advantages. Consequently super will not be an appropriate investment vehicle through which to save for the purpose of helping the child to fund tertiary education costs, or purchasing a home.
Conclusion
Rather than just investing into a savings account or term deposit, the strategies outlined provide alternatives for parents and grandparents.
The minor penalty tax rates are a significant factor in determining how investments for children should be set up. Once the purpose for the investment has been determined, due consideration should be given to factors such as time horizon and a desire for control of the funds, as well as the relevant tax scenarios, to choose the most appropriate ownership structure and vehicle.
The earlier you start saving, the more you can save and invest in your children or grandchildren’s future financial independence.
Important Information and disclaimer
The information in this publication is of a general nature only and is not intended to be used as advice on specific issues. Opinions expressed are subject to change. While it is believed the information is accurate and reliable, the accuracy of that information is not guaranteed in any way. Information contained in this document may not be used or reproduced without the written consent of Simplify Financial Planning Pty Ltd.