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How to invest for children and grandchildren

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The best investment of all is teaching your children how to save, but difficulties arise when you try to put a strategy in place. A major stumbling block for parents appeared when Malcolm Fraser decided to close a perceived loophole whereby wealthy parents invested money in their children’s names to save tax.

In fact, it wasn’t a loophole because the tax office has always had the power to assess interest to the person who they believe is the beneficial owner. But Malcolm had his way and the ”unearned” income of children is now taxed at 66 per cent once it exceeds $416 a year, until it reaches $1445, after which 47 per cent tax applies on the lot.

The regulations are far reaching and “unearned” income includes interest on gifts from grandparents and even family allowance.   

The position is further complicated because most fund managers refuse to accept direct applications from minors because of possible legal ramifications. For example, if a child invested in a share trust and the units in that trust fell in a market crash the child could argue that he or she did not have the understanding necessary to participate in this investment and ask for a refund. Also, while stockbrokers are generally prepared to buy shares in the names of children, the articles of some companies expressly prohibit ownership by people under 18.

Banks are happy to open accounts for children but then they are happy to take money from anybody, particularly when they can pay minimal, or even nil, interest and decimate the balance by fees.

Given that leaving the money in the bank is a disincentive to a child and nobody else will take it, this leaves the parent with three choices: investing it as trustee for the child, investing it in the parent’s name, or investing it in insurance/friendly society bonds that need not create an annual taxable income for the parent or the child. Let’s look at them individually.

Investing by the parent as trustee

This is the most common strategy, but most people have no idea of the possible consequences of doing it. It does not get you around the punitive children’s tax rates because the trustee will be assessed at 66 per cent and there is a major difficulty in that the parent must at all times act as a bona fide trustee and not intermingle trust money with their own.

For example, in a leading tax case a couple accumulated a substantial sum in a trustee bank account and then withdrew it to buy a unit for the use of their children while they were at university. The parents decided to put the unit in their own name and not the children’s name – the Tax Office successfully claimed the money was, in fact, the parents’ money and assessed them for five years’ back interest.

Investing directly by the parent

A better strategy in most cases is to invest in the name of the lowest-earning parent. Provided the parent earns less than $37,000 a year, the maximum rate of tax is 19 per cent and all income derived from franked dividends is almost tax free because of imputation credits. It also reduces the possibility of the Tax Office disputing the ownership because parents are free to give money to their children whenever they wish. The only disadvantage is that capital gains tax will apply if the parent transfers the asset to the child at a later date.

Investing in insurance bonds

Insurance bonds are one of the simplest and most tax-effective investments available. All you have to do is make an investment into the bond and sit back and watch it grow. Then, after you have owned the bond for 10 years, you can withdraw all or part of the proceeds free of tax. However, there is no obligation to withdraw your money and you can leave it in the low tax bond area for as long as you wish.

In many ways, investment bonds are like superannuation. The fund itself pays tax on behalf of the investor, which means there is no need to include any income in the investor’s yearly tax return. However, there are certain critical differences. Superannuation funds pay tax on your behalf at 15 per cent, investment bond funds pay 30 per cent. The amount you can place in superannuation is limited and your money is tied up until you reach your preservation age, which is at least 55. There is no loss of access when you place your money in investment bonds, and the amount you can place in them is limitless. 

The ability to access the investment at any time is a major feature. Your money is not tied up for 10 years and you can withdraw all or part of the balance whenever you wish. If you do withdraw your money early, the profits will be fully taxable, but you will be entitled to a 30 per cent rebate to compensate for the tax already paid by the fund. 

Noel Whittaker is the author of Making Money Made Simple and numerous other books on personal finance. His advice is general in nature and readers should seek their own professional advice before making any financial decisions. Email: noel@noelwhittaker.com.au

NB The third article in the “fairy train” series will run next week. Parts one and two here.

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