Am I better off using a scholarship fund or ETFs for my kids' education?
No matter whether you opt for the local public school or an elite private school, all families face the same pattern of regularly forking out for everything from fees and uniforms, to sports gear, camps and excursions, and of course, the modern must-have – a tablet or laptop computer.
If you’ve ever wondered about the final tally, research by Futurity Investment Group (formerly Australian Scholarships Group – ASG) suggests that from kindergarten to the end of Year 12, the cost of educating your child in 2022 can add up to:
- $83,869 in the public school system
- $143,944 in the Catholic system, or
- $349,404 in the independent school system.
The best way to navigate these costs is to plan ahead. One option is to grow a pool of cash savings. However, the low returns on cash mean you would have to tuck away ever-increasing amounts to meet the costs, which typically rise through secondary school and peak during Years 11 and 12.
Or, you could make extra payments into your home loan or linked offset account. This way your money would at least earn a risk-free return equivalent to your mortgage interest rate – and possibly a higher after-tax return depending on your personal tax rate. Then, when a school bill needs to be paid you can just dip into the offset account or redraw the cash.
The downside is that each time you withdraw money, you lose part of the interest savings that extra repayments or an offset account can provide.
Also, when interest rates are low, you could potentially earn more over time by investing the money in other investments such as share-based ETFs.
Another way to manage education costs is to set up an investment dedicated to funding your child’s education. Plenty of parents are interested in this strategy, and I’m often asked about ‘scholarship plans’, which are basically education bonds. So, let’s take a closer look.
Education bonds are a type of managed investment that offer a tax-friendly way to save for schooling.
Income earned on the bond’s underlying investments is taxed at 30%, with tax paid by the bond issuer over the life of the bond if it is held for at least ten years. When money is drawn down to pay for school costs, the fund can claim the 30% tax back, a saving that’s passed onto parents.
After the 10-year period, earnings can be returned to investors ‘tax-paid’. That’s a plus for mums and dads whose marginal tax rate is above 30%. Bear in mind, if your annual income exceeds $45,000 you could be paying a marginal tax rate of 32.5%. So, you don’t have to be a high income earner to benefit from the tax savings of education bonds.
After setting up your bond, you can keep adding to your investment through ongoing contributions as long as they meet the quirky 125% rule that is a feature of these bonds. This rule limits your annual contributions to no more than 125% of the previous year’s investment. So, if you start out investing with $10,000 in the first year, the most you can contribute in Year 2 is $12,500, and so on.
The 125% rule isn’t just an oddity, it can have serious consequences. If you invest more than 125% of the prior year’s contributions, the bond’s 10-year tax period can re-set, meaning it could take longer to get your money out tax-paid, and it’s usually up to parents to keep track of their annual contributions.
What’s interesting about education bonds is that your money is typically invested across a range of underlying managed funds – some actively managed, some passively managed. Each of these funds charge their own fees, a cost that is passed on to bond holders. In addition the company issuing the bonds will charge its own fees. This is how the bond issuer makes money.
The upshot is that parents opting for education bonds can pay several layers of fees, potentially costing more than 1.40% annually.
This begs the question, could you do better yourself by investing directly in exchange traded funds (ETFs), which typically charge very low fees, often below 0.5% annually?
The case for ETFs
It would be nice to pinpoint whether education bonds or ETFs deliver higher returns over time – and I’m sure that’s what many parents would be keen to know. But it’s not that simple.
The returns your investment will earn depend on your choice of ETFs, and conversely, the underlying investment strategy you choose for an education bond. Both will be impacted by asset market movements over time.
However, there are other issues for parents to weigh up in the education bonds versus ETFs debate.
- Tax savings
While education bonds can deliver attractive tax savings, share-based ETFs can also be very tax-friendly.
The franking credits on underlying shares can be passed directly on to unitholders, and as long as you hold the ETF for over 12 months, any profits on sale can attract a 50% capital gains tax discount.
- Costs to grow your investment
A point in favour of education bonds is that it can cost nothing to grow your investment. You may pay zero fees to set up or add to an education bond.
That’s not the case when you buy into (or sell) ETFs. Just how much you’ll pay will depend on how frequently you trade. If you’re adding to an ETF portfolio on a monthly basis, even very cheap brokerage can add up over time.
- The effort involved
It’s also worth thinking about how you’ll manage your investment. Raising kids takes time and involvement, and from a practical perspective an education bond can be easy to live with. You invest the money and the bond issuer takes care of the rest.
ETFs can call for decisions around what to invest in, and when. On top of this is the need to manage the paper trail of your ETF portfolio for tax purposes. It can be just another chore to add to the already extensive list of a parent’s responsibilities.
Ways around this could be to check if your ETF provider has services that include automated portfolio rebalancing and full tax reporting that can take the guesswork and effort out of growing an investment portfolio built around ETFs.
ETFs have a major point in their favour: the freedom to withdraw money for purposes unrelated to education expenses.
Depending on the education bond you buy into, you may – or may not – be able to withdraw money for purposes other than education, like say, buying a new car. Even if you are able to do this, the tax treatment of your withdrawal can be complex, often depending on how long you’ve held the bond.
With ETFs, you are free to use the money for whatever purpose you like, no questions asked.
This can be a considerable plus. Not only can unexpected emergencies crop up that see you need additional funds you hadn’t budgeted for, you also don’t know how long your child will extend their education for. Some kids leave school at the end of Year 10, others at age 17, and some go on to complete year 12. Not all children will study at university – even though their parents may have factored this into their investment plan.
Know what you’re buying into
If you do opt for education bonds, I stress the need to read the product disclosure statement thoroughly. These can be complex investments, and while there may be tax savings, there can also be tax consequences if you get it wrong. So please, be very sure about what you are buying into.
If you prefer to take a hands-on approach, and you want flexibility around accessing your money, ETFs can tick plenty of boxes. They charge low fees, offer easy diversification and let you select investments based on your views of different asset markets. It’s a pretty good report card if you’re investing for your child’s education.
If you’re unsure about the investment strategy that is right for you and your family, it’s not a bad idea to speak with a financial adviser.