Key Takeaways
- Tax Thresholds for Minors: Children under 18 face significantly higher tax rates on unearned income exceeding $416 to discourage income splitting. Professional advice on ownership structures is vital to avoid unintended tax bills.
- The 10-Year Bond Rule: Investment bonds are "tax-paid" vehicles. If you hold the bond for at least 10 years, the final withdrawal is typically tax-free in your hands, making them a powerful long-term education tool.
- Diversification Thresholds: Building a diversified portfolio of direct Australian shares usually requires a minimum of $50,000. For smaller initial amounts, managed funds or ETFs offer immediate diversification across hundreds of companies.
- Automated Savings Plans: Managed funds allow for "dollar-cost averaging" through regular monthly contributions as low as $100. This discipline helps build significant education funds over time without needing large upfront capital.
- Franking Credit Benefits: Investing in Australian shares or LICs that pay fully franked dividends provides a 30% tax rebate. This can significantly boost the net return of an education fund held in an adult's name.
We all want the very best for our children. We know that a good education not only provides them with qualifications it also provides them with opportunities. Knowing they were given every possible chance to express themselves and learn is probably the best gift you can give a child or grandchild.
We also know that a good education can be expensive. What education savings choices do you have to ensure your “investment” does not become a financial burden? We list three options below:
- Australian share investment
- Managed funds / Listed investment companies (LICs)
- Investment bonds (Insurance bonds and friendly society bonds)
Investing Directly in Listed Australian Shares
Investment in Australian shares which pay fully franked dividends is one option. Imputation credits currently provide a rebate of 30 cents in the dollar. This means you pay less tax on your dividend income. Shares are one of the highest performing investment sectors over the longer term. For the typical five-year timeframe needed for education funding, shares are a strong contender. You can manage these through professional stockbroking advice to ensure quality selection.
Navigating Informal Trusts and Tax for Minors
Children under the age of 18 are not able to enter into a contract. Therefore the account is usually opened in an adult's name as trustee for the child. This is known as an "informal trust". From a tax perspective you must seek professional advice to determine which ownership type is most tax-effective. The trustee or parent could be liable for income and capital gains tax liabilities as a result of presumed ownership.
One drawback with direct holdings is the difficulty in establishing a regular savings plan. Most initial gifts to children are modest. It is hard to achieve cost-effective diversification without at least $50,000 to invest. Placing small amounts in only a few companies leaves you exposed to higher risk if one underperforms.
Using Managed Funds, LICs, and ETFs for Diversification
To overcome diversification issues many advisers suggest using a managed vehicle. An unlisted managed fund or a listed investment company (LIC) are popular choices. The advantage is that a manager makes all investment decisions and handles administration. This includes providing detailed taxation statements for your financial planning records.
Managed Funds and Regular Savings Plans
Managed funds are useful because you can start a regular savings scheme with a modest sum. You can typically start with $1,000 and invest as little as $100 monthly. This approach uses the dollar-cost averaging principle to reduce market timing risk. For investments held more than 12 months only 50% of any realised capital gain is added to your taxable income.
The Role of LICs and ETFs
LICs often show more transparent value than a managed fund. An investor can see this value in the listed share price. LIC annual management fees can also be lower than managed fund fees. However LICs do not usually offer regular savings schemes.
Exchange-traded funds or ETFs are also becoming popular. Like LICs they provide access to various markets with a smaller amount of money. ETFs provide exposure to a basket of shares or property. They often match the performance of a specific index very closely. Management fees are quite low ranging from 0.15% to 0.8% for some offerings.
The Benefits of Investment and Education Bonds
Investment bonds are useful when saving for education. With shares and unit trusts the responsibility for tax is passed to the investor. With investment bonds earnings stay within the fund and tax is paid by the provider.
Understanding the 10-Year Tax-Free Rule
Investors do not need to declare income on their tax return until a withdrawal is made. If the investment is held for 10 years or more there is no additional tax to pay. If you withdraw funds before 10 years you receive a rebate to offset tax. This makes them a favourite for education savings.
Specific education savings bonds are available. They are designed for school expenses but some providers allow flexibility for other uses. Tax is paid by the provider at 30% but the actual rate can be lower due to franking credits. Tax benefits are even better for education expenses because the tax can often be claimed back from the ATO and included in the withdrawal for the student.
Find an Education Savings Specialist
Choosing the right structure for your child's future can save you thousands in unnecessary tax. Our advisers can help you compare bonds, funds, and shares to find the best fit for your family. Find a Morgans adviser today to start a savings programme that grows with your children.
The investment option you choose, should best match your investment objectives and risk profile.
Tax may also play an important role when deciding which investment strategy to use. In that regard, it is important you seek qualified tax advice before implementing your strategy.
Contact your Morgans adviser or nearest Morgans office for more information.
Frequently Asked Questions
How are children taxed on investment income in Australia?
Children under 18 have a very low tax-free threshold of $416 for unearned income like dividends or interest. Income above this amount is taxed at the highest marginal rate of 45% plus the Medicare levy. This is why many parents use investment bonds or formal trusts to manage education savings.
What is an investment bond 10-year rule?
The 10-year rule allows you to withdraw all earnings and capital from an investment bond tax-free after a decade. During those ten years the bond provider pays tax on the earnings at 30% so you do not have to report the income in your personal tax return.
Can I start a regular savings plan for my kids with $100?
Yes. Many unlisted managed funds allow you to establish a regular savings plan with as little as $100 per month after an initial minimum investment. This is an effective way to use dollar-cost averaging to build wealth for future school or university fees.
What is the difference between an education bond and an investment bond?
Education bonds are a type of investment bond with extra tax benefits specifically for education costs. When you use the money for legitimate education expenses the bond provider can often claim a "tax benefit" back from the ATO which is passed on to the student.
Do I have to sell my shares to pay for school fees?
Not necessarily. You could use the dividends produced by the shares to pay for fees. However if the shares are held in a child's name via an informal trust you must be careful of the high tax rates for minors. Holding them in a parent's name might be better if you can use the franking credits to offset your own tax.
