Investing for your kids: Everything parents and grandparents need to know
Starting children on their investing journey early in life can be a great way to set them up financially for the move into adulthood.
The “bank of mum and dad” is now one of Australia’s biggest home lenders, and boomers are going to extreme lengths to get their adult children on the property ladder. But there’s another way to give children a financial head start from a much younger age.
Starting them on their investing journey in their early years can be a really great way to set the kids (and grandkids) up financially for the move into adulthood.
The key here is time, and the magic of compounding. Even small amounts put away early on can grow to a decent pot by 18 and beyond.
When it comes to investing for your children, the experts say you should always have an end goal in mind before you take the plunge.
“I often see people putting away $50 or $100 a week, but that amount doesn’t actually align with what they’re trying to achieve,” says financial adviser Glen Hare of Fox & Hare Wealth, which specialises in providing wealth advice to people aged 20 to 45.
“If you want to help your kids buy their first car, you’re going to need to put away a lot less than someone who wants to help them buy a property. So it’s important to understand the goal and work backwards from there because if someone wants to help their child purchase their first home, putting away $50 a week might not cut it.”
For parents and grandparents who want to get their kids or grandkids’ investment journey started, there’s several options out there, and potential pitfalls to avoid.
Crucially, you don’t want to get caught out on tax. In general, minors are subject to much higher tax rates on investment income than adults. Only the first $416 a year is tax-free. After that, the tax office slaps eye-watering rates on income for under 18s: 66 per cent for earnings between $417 and $1307 and 45 per cent for earnings above that.
There are exceptions for some minors, including children with disabilities. Children who are the principal beneficiaries of a special disability trust or are permanently disabled pay the same income tax rates as adults. This means the first $18,200 of investment income earned each year is tax-free.
According to the ATO, a minor qualifies for this exception if they are entitled to a disability support pension, if their carer receives the carer allowance for them, or if they are disabled and likely to suffer from that disability permanently or for an extended period.
Savings accounts and term deposits
Bank savings accounts or term deposits are the easiest way to get children started on their saving journey. They’re safe, secure and low-cost, and there’s plenty in the market, including from the major banks.
The major lenders currently offer rates of about 4.5 per cent, with conditions. Others in the market are slightly higher, including Teachers Mutual’s Mighty Saver account, which currently has a 4.75 per cent rate and no conditions such as minimum monthly deposits.
Term deposits are another option to lock away money for up to five years at a set rate and a guaranteed return at the end of the term. Returns are currently a little lower than on offer with savings accounts.
While bank savings accounts and term deposits are risk-free, the returns are pretty ordinary. Keep in mind that rates will probably go down from here and, as mentioned, you hit the tax threshold pretty quickly.
If you think the annual earnings will stay below the tax-free threshold for minors, opening a bank account in the child’s name probably makes sense. But if there’s a chance earnings will be well above $416 a year and you don’t fancy giving the tax office 66 per cent above that, it may make more sense to have the account in the name of the adult in the family with the lowest marginal tax rate and pay the more palatable tax liability.
Shares, ETFs and managed funds
Investing in shares, exchange-traded funds or managed funds is a great way to give the kids a leg-up and educate them early about growing wealth.
For those starting out, popular investing options include Vanguard for Kids, Stockspot, and microinvesting platform Pearler. CommSec and Nabtrade also have options for minor accounts, while Betashares is gearing up to launch its own children’s offering.
Pearler and Vanguard have very low minimum investment requirements of just $5 and $25 respectively, while Stockspot’s minimum investment is $2000. Stockspot doesn’t charge fees on children’s accounts with balances below $10,000.
Buying shares for children has become more and more popular in recent years. Grandparents are clearly keen on the trend too.
“It’s become a bit of an alternative for gifts,” Stockspot founder Chris Brycki says of the children’s investing accounts. “Parents or grandparents will set up the account, and then when it’s a kid’s birthday or Christmas, instead of buying toys they’ll top up the account.”
Most parents choose Stockspot’s high-growth option because of the long-term investing horizon. This option returned 18 per cent for the 12 months to June 30, double what some of the biggest super funds in the country returned for their members over the same period.
Who owns the shares?
In terms of share ownership, there are a few options. The first is to purchase in the adult’s name, with tax on dividends paid at the adult’s marginal rate. If you’re in a couple, advisers suggest putting the shares in the name of the person on the lowest income so you pay less tax.
Another option is for the parent to purchase the shares as trustee for the child. This creates an informal trust where the adult is the owner and operator of the account, while the child is the beneficiary of the trust. In Australia, children can’t legally own shares or ETFs but can have beneficial ownership.
If the child’s tax file number (TFN) is listed on the account, the child will pay penalty tax rates on any income over $416 each year, but there won’t be any capital gains tax to pay when ownership is transferred when he or she is an adult. Again, these penalty tax rates won’t apply to children with disabilities.
One way around the tax hit is to avoid dividend-paying stocks and go for growth stocks when investing for children, KPMG Australia tax partner Kudzai Chipangura says.
“It just requires you to be savvy as an investor,” he warns. Keep in mind that growth stocks are a much riskier choice than blue-chip dividend earners.
If, on the other hand, the parent’s TFN is listed on the account, the parent pays any tax owed at marginal rates. In this case, CGT may be triggered when you move to transfer ownership later on.
Investment bonds
Investment bonds are another investment to consider, in part due to their tax structure.
Investment bonds are long-term products typically offered by insurance companies or friendly societies. You can invest in growth or defensive assets and earnings are taxed within the fund rather than your personal tax return.
“Often when people think about bonds, they’re thinking about fixed interest and a defensive or conservative-style investment. An investment bond is purely the structure in terms of the underlying investments. You can still invest in higher growth assets like shares,” Hare says.
“What an investment bond does is it caps the amount of tax that’s paid at 30 per cent. So if you’re a high-income earner on a tax rate of 47 per cent, there’s an immediate tax benefit.”
The other benefit with insurance bonds is you can change the beneficial owner with no tax implications. But fees can be high, so keep note of what providers are charging before you step in.
The investment should be held for at least 10 years and there is a 125 per cent rule on contributions that means you can’t put in more than 125 per cent of what you topped up by the year before. So if you contribute $10,000 in year one, the most you can add in year two is $12,500. If you contribute zero in any year, you can no longer contribute to that bond. Your options are to start a new bond or restart the 10-year period. After 10 years, earnings are tax-free.
Family trusts
Finally, family trusts are often used by wealthy families for their tax benefits as the structure allows income to be distributed among beneficiaries on lower rates of tax. But it’s not a useful option for distributions to minors as they still incur the much higher tax rates, even in family trusts.
Best option?
The best option really depends on your circumstances, but if we take the two most popular ways parents invest for their children, being bank accounts and shares, shares have delivered much better returns over the long term.
Investing $100 a month into a savings account for a child from birth to 18 would give them about $33,000 if rates stayed steady at 4.5 per cent. On the other hand, that same $100 invested into the sharemarket would deliver $48,000 at an 8 per cent annual return, and $60,000 if returns averaged 10 per cent a year. This is only a crude comparison and does not take into account tax payable on earnings, but with such a long-term investing horizon shares seem an obvious win when looking an options giving children a financial head start.
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