Raising children is one of the biggest expenses parents will incur and although in most cases the emotional rewards offset the costs, it is still a smart move to put money aside for when the bills roll in, to pay for the children’s education or simply to give them a good start later in life.
However, investing for children can be costly for the adult if he or she is not aware of how the investment is treated in relation to tax. Investing in a child's name can attract a tax liability of up to 66%.
In this update we discuss the more common issues surrounding investing for minors. (Note, we are not tax advisers and recommend specific tax advice is sought from a qualified accountant or tax agent before entering into any arrangement.)
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Children and tax rates
There are very few options to invest directly in a child’s name without being hit with a punishing tax bill. Child tax rates are designed to deter parents from sheltering income in their child’s name in order to reduce their own marginal tax rate.
Excepted persons and income
Not all children are subject to the punitive tax rates. There are several categories of minors who are referred to as excepted persons and are taxed at ordinary rates.
These include people:
- Who are working full-time, or who have worked for more than three months and are intending to work full-time;
- Entitled to a disability support pension or rehabilitation allowance; or someone entitled to a carers allowance to care for them;
- Permanently blind or disabled;
- Entitled to a double orphan pension;
- Unable to work full time because of a mental or physical disability.
Certain sources of income are also considered excepted and are taxed at ordinary rates, ie, as an adult would be taxed, or not taxed, whatever the case may be. This includes:
- Employment income;
- Compensation, superannuation or pension benefits;
- Income from a deceased estate;
- Lottery winnings;
- Income from a business or partnership;
- Income from a property transferred to the minor as a result of the death of another person, family breakdown or to satisfy a claim for damages for an injury they suffered.
Tip
A common strategy is to establish a testamentary trust to hold assets and distribute income to minor children who have inherited monies from a deceased estate.
The primary reason being that income distributed from a testamentary trust is taxed at adult marginal tax rates, rather than the penalty rates applicable to minors.
Consider, however, that income derived from the direct investment of capital proceeds received via a deceased estate also receives the same taxation treatment, i.e. taxed at adult marginal tax rates.
This may be a simpler and cheaper alternative to establishing a testamentary trust as the tax outcome is the same.
Ownership of the investment
In most instances, it is generally more effective for the investment to be in the name of the person putting the money forward, such as a parent or grandparent (as trustee for that child).
This is due to the fact minors are generally prohibited from entering into legally binding contracts and ownership arrangements.
As a result, where money is deposited into a bank account or other investment for a child, it is not unusual for an adult parent/guardian to act as a trustee on the child’s behalf.
For example, the parent of Tommy Smith is Bill Smith. The investment may appear in this name: Mr Bill Smith <Tommy Smith a/c>. It is important to note that this is not a formal legal structure. Bill Smith is the legal owner of the asset.
This type of informal trustee arrangement does not generally involve the establishment of a formal trust deed or other legal document.
A formal trust can be established for the child (or a larger family group) but this involves significant establishment and ongoing legal and financial costs.
These can be warranted when the assets are of reasonable value and income from them may take a child into the highest marginal tax rate.
Advice and assistance on the establishment of any trust structure should be sought from a solicitor or accountant qualified in this area.
Tax File Number
If a Tax File Number (TFN) is not provided at the time of investing, tax at the top marginal tax rate (47%) can be withheld from investment earnings (excluding franked dividends). The question is, whose TFN should be quoted?
If the investment is established in the child's name then it is the child's TFN that is quoted to the financial institution or share registry (a child can get a TFN at any age).
If the investment is in the name of an adult as trustee for the child (as an informal trust arrangement) then the adult will quote their TFN.
If the investment is via a formal trust for the child, then it is the trust's TFN that is quoted (e.g. if held in a testamentary trust).
Ownership and tax issues
If it is established the adult ultimately owns the investment then instead of attracting minor penalty rates, earnings on the investment will be included in the adult's assessable income and taxed at his or her marginal tax rate.
If the adult is a grandparent, this may affect their eligibility for concessions such as the Senior Australians Tax Offset or the Low-income Tax Offset. It may also affect their Medicare levy payable.
If the grandparent is receiving Centrelink benefits there may be adverse implications as the investment could be asset tested and deemed.
Later on when the asset is to be transferred into the child’s name there may be gifting and capital gains tax issues, depending on the ownership situation. To help clarify ownership issues, the Australian Taxation Office (ATO) has provided some specific guidance on this issue on the ATO website.
The advice in the ATO's fact sheet "Children's share investments" rests mostly on the consideration of who rightfully owns and controls the investment (in this case, shares) and who benefits from any income generated from them.
The ATO offers this caution: "If there are large amounts of money or a regular turnover, you might need to examine the ownership of the shares further. You might need more information to work out who should declare the dividends."
A final word on the issue of tax and ownership issues, if there is a condition placed on the investment – that is, the child will only benefit from the investment if they meet a specified condition e.g. passing senior, attending university, buying a car – then ownership could rest with the adult for tax purposes.
This is because if the condition is not met by the child, then it is assumed the adult will retain ownership of the investment.
Strategies for adults considering investing for minors
Consider whether it is likely that the child's investment will generate income above the tax-free limit consistently over the life of the investment.
If the answer is no, then you should consider treating the income as belonging to the child. However, be careful to ensure all income generated from the investments is used only for the benefit of the child and the easiest way to show this is to reinvest it.
If you do withdraw it and use it for the child’s needs (education or otherwise) keep very good records to account for this use.
If the answer is yes, you should consider using a trustee with a low tax rate or use an investment vehicle like a trust or insurance/education bond or warrant.
The value of dollar-cost averaging
It is common for parents or their relatives to offer gifts to children in the form of an investment. This could be by way of a lump sum investment on behalf of the child or a regular savings facility, which can be drawn from at any given point in the future.
A regular savings facility includes the benefit of dollar-cost averaging – that is, the benefit of purchasing investment units at differing prices. The regular investment purchases less units when prices are high and more units when prices are low.
By averaging the unit price paid, the investment cost is reduced. Speak to your adviser for more information on regular savings facilities.
If you need more guidance on where to start when investing in your children's future, talk to your Morgans adviser or contact your nearest Morgans office.
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