Investing for Minors

Many parents and grandparents wish to invest for the future benefit of their children. Individuals considering investing on behalf of minors (under 18s) should be aware that such investments have income and capital gains tax consequences for both the adult and minor.

Children under 18 cannot invest in their own name. The investment would need to be taken out by the parent who would hold it in trust for the child. For example, an investment may be titled as follows: Homer Simpson ATF (As Trustee For) Minor Bart Simpson.

In some situations, adults holding an investment on behalf of a minor will be liable for tax on the income generated by that investment; in other situations they will not. This makes it important to carefully consider the tax implications and administration processes to ensure no excess tax is incurred.

Identifying beneficial ownership: The source of the capital invested, control of the investment and use of the proceeds determine whether the tax liability will lie with the adult or the child. This can vary depending on the situation and is generally determined on a case-by-case basis.

If it can be proven that the income generated by such an investment is not in any way for use by the adult, then the adult will not be liable for tax on that income. For example, if the income were being re-invested or used to cover expenses such as school fees for the child, then the adult should not personally be liable for tax on the investment. Instead, the child will be liable for the tax and it will be necessary to include the income generated by this investment in a tax return for the child. This income is subject to special taxation rules.

Tax implications: Income of minors is categorised as either “excepted” or “eligible” income; the two are treated differently for taxation purposes. Excepted income represents income earned by the child, such as a salary generated from part-time employment. This income is taxed at ordinary individual tax rates.

Eligible income covers money the child has received, but not earned through their own efforts. This includes interest from bank accounts and other investments and dividends from shares. Higher tax rates apply to unearned income of minors to discourage high income earners splitting their income with their children. The tax rates on eligible income for children under 18 are:

*The low income offset can effectively increase the tax-free amount of income from $416 to $772. The maximum low income tax offset will be applied if the income generated is less than $21,600.

As an example, take Joe, a keen saver, aged 15 who is the youngest son of John and Cathy. In 2005-06 Joe will have earned $2200 in interest from his online savings account (held on his behalf in Cathy’s name) and will be taxed as follows:

*This amount does not include the Medicare Levy of 1.5%. This may be payable depending on the applicability of the Medicare Levy low income threshold.

Note: Proposed changes to tax rates, thresholds and offsets, which may increase the tax effectiveness of investing on behalf of minors, are due to take effect from July 1, 2006. The low income tax offset will increase from $235 to $600 and the maximum offset will apply for those earning less than $25,000 (up from $21,600). This will effectively increase the tax-free amount of minor income from $772 to approximately $1326. Further, the tax rate on minor’s income above $1445 will be subject to a reduced 45% tax rate. At the time of writing, legislation to give effect to these changes was still before Parliament.)

Capital gains tax implications on transfer: If the investment is switched or sold by the adult while the child is still a minor, a capital gains tax (CGT) liability will arise for the minor. Given the high tax rates applicable to minors, this liability could be significant.

If the investment is held for the sole benefit of the minor throughout the life of the investment, and it is transferred to the minor when the minor attains the age of 18, then there is no deemed beneficial change in ownership, and therefore no CGT implications at that point.

Tax file numbers: It will be necessary when establishing an investment on behalf of a minor to supply the tax file number of the adult to the fund manager or financial institution. This is because the adult is the legal owner of the investment and not the child. If the only source of income for the child is eligible income (such as interest), and the amount earned in a year is less than $772, no tax return is required. However, once the investment produces income greater than $772, the child will need to lodge a tax return and pay the appropriate tax.

Administration: It is important to keep documented evidence that the income is for the sole use of the minor. Documents such as school fee receipts that match withdrawals from the investment should be maintained until the child turns 18. Additionally, if the intention is to transfer the investment to the minor upon turning 18 years, and the income is intended to be reinvested and never spent, this should be clearly stated.

It is recommended investors take three steps prior to investing on behalf of a minor:

• Keep documented evidence that the income is for the sole use of the minor.
• Clearly state the intention to transfer the investment to the minor upon turning 18 years.
• Investigate all CGT implications.

Product suitability: Most unit trust investments, bank accounts, term deposits and similar investments are suitable options for investing on behalf of minors. It is essential that before commencing such an investment, calculations are performed to establish the level of income the investment is likely to produce, to determine the most suitable ownership structure.

Insurance bonds and friendly society investments may also be worthy of consideration to achieve the goal of investing on behalf of a minor. The return produced from these investments is taxed in the hands of the life company, and the net returns reinvested. Thus the investor is not subject to an ongoing tax liability and if certain conditions are met the investment can be withdrawn tax-free after 10 years. As the insurance company’s tax rate is 30% this is more tax-effective in many cases.

These investments also offer benefits in that the child (or the parent of the child where grandparents or god parents are the investors) need not know of the existence of the policy until the child reaches vesting age. In this way, money can be protected from possible family difficulties.

Alternative solutions: An obvious alternative to holding investments on behalf of a minor is to invest directly in the name of the spouse on the lowest marginal tax rate and reinvest the net return. This minimises the tax paid on the return generated by the investment. However, capital gains tax will be payable on sale or transfer to the child.

Other investors may consider setting up a family trust and distributing income to all members of the family or those members who have little or no other income. A third alternative is for a parent or grandparent to invest in tax-deferred products such as an insurance bond.

It is advisable for individuals to discuss any investments made on behalf of minors with their financial planner or accountant to clarify their tax options.

Anne-Marie Esler is the Technical Research Manager of Centric Wealth.