Eight ways to invest for your children

Investing for or by children is complicated. The Australian Taxation Office has complex rules put in place to dissuade parents from paying less tax on income and assets they might split into their children's names. Financial institutions generally don't like to enter into contracts with minors in case they are unenforceable. On top of that, child-parent-grandparent-son/daughter-in-law dynamics can be complicated and become especially so when it involves money.

However the benefits of investing for children – or investing being done by children themselves – are too important to give up on. Here are eight things you might not know.

1. $10,000 is generally the maximum gift a kid can invest tax free

The tax rate on children's investment income varies widely between minus 42% and plus 66%.The ATO doesn't mind children under 18 earning money and investing it but it doesn't like them investing unearned money gifted to them. Where income from investments is above $416, a tax return for a minor needs filing and tax is levied on so-called unearned income above this limit at the highly penal rate of 66%, falling to a slightly less oppressive 45% on monies above $1,307. This link provides some rules on tax rates and filing requirements. Children aren't penalised for certain “excepted income”, like their own employment earnings and investments made from those, and some children like those with disabilities are exempted.

Assuming an income yield of 4%, then $10,000 is about as much tax-free gifts your child or grandchild aged under 18 can hold before tax on investing becomes so excessive it looks like theft. 

While gifting is tax free in Australia, age pensioners and other Centrelink beneficiaries may not be allowed to gift more than $10,000 (couple annually) or $30,000 over five years before benefits might be cut.

2. Youngsters aged under 18 can earn up to $20,000 tax free on their own money

If you can encourage your child or grandchild to save and invest income from their paid work, then like for those over 18, they don't pay any tax on that investment income until it and paid work exceed $20,542 annually. This amount comes from the relatively high tax-free income threshold plus the low income tax offset. Recall the former was raised from $6,000 to $18,000 to compensate low income earners from the former carbon tax – thankfully the concession remains. Assuming the same 4% yield, you and your son or daughter, under or over 18, don't need to pay tax on income from their own sweat and entrepreneurialism until investments exceed $500,000.

3. Franked investment income is very attractive

Just like pension investors, nil tax payers are also entitled to a refund of franking credits. If a minor or young adult's tax income is only $100 of franked dividend, then they are entitled to a $42 tax rebate. This makes the marginal tax rate on franked income a minus 42%. Note if a tax return isn't filed a form can be used to claim this rebate.

4. Estate planning has some child-friendly choices

Sadly the best way to invest for and by children requires you to die.

Unearned income from assets arising from an estate is exempted from the penal minor tax rates discussed above. The best way to take advantage of this is to rewrite a will to ensure a son or daughter and/or their grandchildren can choose to inherit assets through a trust created from an estate on death – a so-called Testamentary Trust. For those familiar with a discretionary Family Trust, a Testamentary Trust is very similar, except income distributed to children under the age of 18 is taxed at adult rates – thus tax free up to about $20,000. Please note the primary reason I recommend a Testamentary Trust is for asset protection to make sure your money has a higher chance of staying in your family. Unless you think your son or daughter is going to use up an inheritance immediately to prudently pay down a jumbo mortgage, you or your parents should consider “investing” in extra legal fees to update wills to create the option for inheriting via Testamentary Trusts – ideally one for each beneficiary.

Testamentary Trusts deal with assets from an estate which can include assets paid to it from super, but not always – sometimes you need to make a binding nomination for that to happen. However it may be better still for investments to stay in super for a dependent where they can be used to fund or continue a tax-free compounding pension. In addition to doing so for a dependent spouse it is also possible to leave some or all these assets for dependent children. A child allocated pension is like a retiree's account-based pension however it terminates at age 25 where remaining assets must be paid out as a tax-free lump sum. Speak to a lawyer and/or financial adviser to explore the merits and ways to leave some money investing for any children under 18 in super. In public offer funds that allow this, this generally requires making a binding nomination of some of the assets to them.

5. How $10,000 now could finance a distant retirement

For about the price of a new car a teenager can prepay their retirement.

Perhaps Einstein was thinking about long-term investing for children when he reportedly said: “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn't, pays it.” Assuming a very healthy investment return of 10% annually, $23,000 invested for an 18-year-old (or $10,000 for a 10-year-old) will grow to $2 million by their age 65. In today's dollars that has the buying power of just under $0.5 million assuming annual inflation of 3%. By my reckoning (see How much is enough?) that would be enough today to fund a modest single person's $23,500 annual retirement spending according to ASFA. Of course it's hard to turn off employer super contributions so either you can look at this as base loading a more generous retirement or choose a lower initial investment. 

If this curiosity appeals, you need to know a few things:

- While gifts to a minor are tax free, only the recipient person can contribute that tax free to super as a personal contribution – otherwise they are treated as a concessional contribution, like those from an employer being taxed at 15% (all subject to limits)
- Children under 18 can have a super fund set up for them by an employer, for instance when they make more than $450 in one month and work more than 30 hours per week, or can personally apply to a fund that accepts minors (many do)
- With the help of a lawyer it is possible, but not generally advisable, to make a child a member of your self-managed super fund
- If a personal contribution was made by someone working and earning under $49,488 they may be eligible for up to a $500 half-matching non-age tested co-contribution benefit. 
- Super is a great place to selfishly fund your children's catastrophic lump sum insurance needs – perhaps even paid for by the co-contribution benefit if eligible. I never miss the opportunity to remind parents of young adult children to ensure their children arrange life insurance. Until they do, parents are their insurer and put their retirement at risk
- Penal tax rates on unearned income discussed above do not apply to funds in super. They are taxed under superannuation rules which don't discriminate against the young. The average tax rate in super in accumulation is usually under 10% after franking credits are counted
- While not quite Hotel California, money contributed to super for the young under current rules is likely locked up to at least age 60 which will make Einstein happy.

6. Plain truth – there really aren't any tax breaks for education investment

Unlike other countries, the ATO doesn't give you any meaningful breaks for putting away money to be spent on education. While I'm a big fan of disciplined saving strategies and appreciate products like those offered by Australian Scholarships Group and Lifeplan, they invest through a tax paid insurance/friendly society bond structure and sometimes can be low returning.

Insurance bonds are a 30% rate, tax paid, investment structure which could be suitable for investing for a minor. After 10 years, benefits paid don't incur additional tax, especially if the recipient is then over 18 (see Insurance bonds a super complement).

Generally I find the best investment for a young family to fund school fees is paying down their non-deductible mortgage faster. If funds are needed to part pay schooling they can be drawn back then.  A few schools may offer early payment plans but the details of these vary, including whether above-inflation fee rises are avoided (please!) and on what circumstances the money can be reclaimed. Some grandparents draw from their own tax-free compounding super pension to pay grandchildren's school fees as a wonderful investment in the bloodline. 

7. Your (grand)child's first investment should be STW, VAS or IOZ not BHP, CBA, WOW …

I must admit to nearly not having a career in financial services as my first shareholding, bought for me by my well-meaning geologist father, was serial underperformer the International Nickel Company of Ontario – now merged into Brazilian and BHP competitor, Vale. If you want to avoid the curse of picking the same for your loved one, I would suggest first gifting monies to buy into the broader market using an exchange-traded fund.

Funds STW, VAS and IOZ let your (grand)son or (grand)daughter enjoy the dividend income and capital growth from about 200 shares listed on the Australian share market and insulate you from picking a dud. While you could also invest in a listed investment company (see our LIC spotlight series: Templeton Global Growth Fund, Perpetual Equity Investment Company and AMP Capital China Growth Fund) the link to the holdings is more complicated, including possibly by a swinging premium or discount to assets.

Another great reason to have an index fund first in the portfolio is it can be used as a readymade benchmark that these other speculative investments' success can always be measured against. An index fund is also a practical way to get some international equity exposure into the portfolio and protect the overseas gap year holiday perhaps from a falling Australian dollar.

I'm of two minds whether to recommend electing dividend reinvestment plans. When done it helps grow investments faster, however, there is great educational merit for a young capitalist to be reminded by regular dividend cheques or deposits.

Note stock brokers require a minimum marketable parcel of $500 and brokerage accounts can't be opened in the name of the minor – but can be done so in in trust for them.

A perhaps fading alternative to direct stock ownership is using off market purchased managed funds which sometimes can be bought with smaller initial investments if a regular investment plan is committed to.

Once invested the ATO has some more tips on who pays tax on dividends and distributions.

8. Don't gift your children a home down payment, lend them one

The cost of housing in Australia is so oppressive that it isn't surprising some parents help their children out at least with part of a down payment. Unfortunately with divorce rates more than 50%, realise that if you do this with two children, it's statistically likely that some of your money will leak away in a future separation.

To better protect your interests, rather than gift funds, you could work with a lawyer again to explore lending funds, including even interest free. For greater security register this mortgage on the title. Note that a loan from a Testamentary Trust could be a possible source of funds, but again seek advice. Lending is probably preferable to co-owning a home with a young adult as the latter might create ongoing land and future capital gains tax issues. If you get an objection to lending not gifting, feel free to blame me. 

Finally, if all this complexity puts you off your educational goal, there is of course one very powerful way to teach children the value of a dollar … just borrow some from them!

Dr Douglas Turek is managing director of wealth advisory and money management firm Professional Wealth (www.professionalwealth.com.au) and a Director of Wills & Wealth (www.willsandwealth.com) succession lawyers. References to tax, legal and investment concepts and financial products here are for educational purposes only and are not to be relied upon or treated as advice – please seek assistance from a/your accountant, solicitor or financial advisor before making any decisions or do your own research.