Investing for Children

By on 15 Jun, 2024

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Overview and Taxation

Investing in your child’s future and teaching your child to do so represents not just a financial commitment, but a profound gesture of love and foresight. In Australia, parents and guardians are fortunate to have a myriad of options at their disposal for securing their children’s financial future. From educational savings accounts to trust funds, the choices are diverse and can be tailored to suit different needs and aspirations. However, navigating this landscape requires a keen understanding of investment strategies, tax laws, and the nuances of financial planning for minors. This guide is crafted to demystify the process of investing for children in Australia, offering a comprehensive overview of the available options, alongside key considerations, and strategies to maximise your investments’ potential while staying compliant with tax regulations. Whether you’re a new parent planning for your newborn’s future or looking to expand existing investments for your teenager, this guide will serve as a valuable resource in your financial planning journey.

Understanding the Basics of Child Investment in Australia

Legal Framework and Tax Implications:

Investing for minors in Australia operates within a specific legal and tax framework. The key to successful child investment lies in understanding these rules. Firstly, while minors can legally own investments, they cannot manage them until they reach the age of 18. Therefore, investments must be held in trust, either informally (in the parent’s name) or through a formal trust structure.

The tax implications of earnings from these investments are crucial. Under the Australian Taxation Office (ATO) regulations, investment income earned by children under 18 is taxed at a higher rate if it exceeds certain thresholds. This is to prevent parents from reducing their tax liability by shifting income to their children. For the 2023-2024 financial year, for instance, the tax rates for minors on unearned income (such as interest, dividends, and rent) are 0% for the first $416, then 66% up to $1,307, and 45% thereafter.

Setting Financial Goals and Investment Horizons:

Establishing clear financial goals is the cornerstone of any investment strategy. For child investments, these goals could range from saving for education, accumulating a deposit for their first home, or simply building a nest egg for their future financial security. The investment horizon, or the period over which you intend to invest, is equally crucial. Typically, longer horizons allow for more aggressive investment strategies, as there’s time to ride out market fluctuations.

Choosing the Right Investments:

The choice of investment should align with both the financial goal and the investment horizon. Generally speaking, for short-term goals, less risky investments like high-interest savings accounts or term deposits might be suitable. However, for long-term goals, considering shares, managed funds, or bonds can be beneficial as they offer the potential for higher returns over time, albeit with higher risk. A wealth advisor will be able to advise.

Understanding Risk Tolerance:

Risk tolerance is a key factor in choosing investments. It’s essential to assess how comfortable you are with the possibility of losing money in exchange for the potential of higher returns. A diverse portfolio can help manage risk, spreading investments across different asset classes to buffer against market volatility.

Guardianship and Control:

Until children reach adulthood, their guardians have control over their investments. This control should be exercised with the child’s best interests in mind, considering the long-term benefits and potential risks. It’s also important to plan for the transition of control once the child becomes legally capable of managing their investments.

Investment Options for Children

1. Savings Accounts and Term Deposits:

For many Australian parents, the journey of investing for their children begins with a simple savings account or term deposit. These are low-risk options and are ideal for accumulating funds over the short to medium term. Child savings accounts often offer competitive interest rates, and some come with no account-keeping fees, making them an attractive option for small, regular contributions. However, it’s important to note that the interest earned is subject to the higher tax rates applicable to minors’ unearned income.

2. Education Savings Plans:

Education savings plans, such as Education Bonds or Education Savings Accounts, are specifically designed to help save for a child’s education expenses. These plans can offer tax benefits, such as tax-free withdrawals if the funds are used for educational purposes. They also often allow family and friends to contribute, making them a communal effort to support the child’s educational journey. It’s crucial, however, to understand the specific terms and conditions, including contribution limits and withdrawal rules, associated with these plans.

3. Shares and Managed Funds:

Investing in shares or managed funds can offer higher potential returns, suitable for long-term goals like saving for a home deposit or substantial nest egg. These investments are subject to market risks but can be rewarding over longer periods. Parents can invest in individual shares or managed funds on behalf of their children, but they need to be mindful of the tax implications of dividend income and capital gains. Managed funds offer the advantage of professional management and diversification, reducing the risk compared to individual stock investments. Again, a wealth advisor will be able to advise.

4. Exchange-Traded Funds (ETFs) and Bonds:

ETFs and bonds present another avenue for child investment. ETFs are investment funds traded on stock exchanges, much like stocks, offering diversification and lower costs. Bonds, being debt securities, provide regular interest income and are generally considered lower risk than shares. Both options can form part of a diversified investment portfolio, catering to different risk tolerances and investment horizons. It is best to seek professional advice from a wealth manager as these options can be very complicated.

The Role of Trust Funds in Child Investment

Trust funds play a significant role in the landscape of child investment in Australia. A trust fund is a legal arrangement where assets are held and managed by a trustee for the benefit of the trust’s beneficiaries (in this case, the children).

Types of Trusts:

There are several types of trusts, including discretionary trusts, fixed trusts, and testamentary trusts. See our previous articles. Discretionary trusts offer flexibility in how distributions are made to beneficiaries. Family trusts are typically used for wealth and asset protection and tax planning. A testamentary trust is a form of trust that is created under the terms of a will or a codicil of a will. It comes into effect only after the death of the testator/testatrix, the person who made the Will.

Benefits and Considerations:

Setting up a trust fund can provide tax advantages, asset protection, and a structured way to manage and distribute assets for a child’s benefit. Trusts can hold various types of investments, including cash, shares, and property, and the income generated can be distributed in a tax-effective manner. However, trusts are subject to their own set of tax rules and legal obligations and setting up and managing a trust can involve significant costs and complexity.

Establishing a Trust:

Establishing a trust involves creating a trust deed, appointing a trustee, and defining the beneficiaries. Professional advice is essential to ensure the trust is set up correctly and operates in compliance with legal and tax obligations. The choice of trustee is critical, as they will have the responsibility and authority to manage the trust’s assets in the best interests of the beneficiaries.

Tax Implications and Strategies

Investing for children in Australia comes with unique tax considerations. Parents and guardians need to understand these implications to ensure tax efficiency and compliance.

Unearned income

First and foremost, it is crucial to understand the “Unearned Income” definition when it comes to the taxation of minors’ taxable income. Any income passively derived (ie not derived from the individual’s personal exertion), will be subject to the higher tax rates. These include:

Please note that minors are not eligible to claim the low-income tax offset (LITO) in relation to unearned income. This means the maximum amount of unearned income a child can receive tax-free is $416 per annum.

Taxation of Minors:

As mentioned earlier, the income earned by minors from investments is taxed at a higher rate beyond a certain threshold. This is to prevent income splitting – a practice where income is diverted to children to take advantage of their lower tax rate. However, there are strategies to manage the tax impact effectively.

On the other hand, if a low-income spouse earns the income, it is then assessed at their marginal tax rates rather than at the hands of the minor taxed at the highest rate. The tax-free threshold may allow some or all investment income to be exempt from tax and franking credits (if any) from investments can be offset against income tax or refunded.

Strategies to Minimise Tax:

  1. Invest in Growth Investments: Investing in growth assets like shares or property, which primarily gain value through capital growth rather than income, can be a smart strategy. Capital gains are not realised until the asset is sold, and if held for more than 12 months, are eligible for a 50% capital gains tax discount.
  2. Investment Bonds: A combination of insurance bonds and a diversified portfolio of other investments, can be a tax-effective option. No income distributions are made and they are taxed within the bond at a maximum rate of 30%.
  3. Education Bonds: Contributions to education bonds are made with after-tax dollars, and earnings are tax-free if used for educational purposes.
  4. Family Trusts: Using a family trust can allow for income distribution in a tax-effective way, though it requires careful planning and compliance with trust laws.

Reporting Investment Income:

Any income earned from investments in a child’s name must be reported to the Australian Taxation Office. It’s important to keep accurate records of all investment transactions to ensure correct reporting and compliance.

Where there is an informal trust arrangement, the trustee’s TFN is quoted. However, under formal trust arrangements, the trustee of the trust has the obligation to withhold tax for any beneficiary who is under a legal disability (which includes a minor). Accordingly, the assessment of the trustee’s tax is determined as if taxed in the hands of the child.

Planning and Professional Advice

While this guide provides a foundational understanding of investing for children in Australia, personalised financial planning and professional advice are invaluable.

Developing a clear, well-thought-out financial plan is crucial. This plan should consider the long-term financial goals for your child, the appropriate investment options to achieve these goals, and a strategy to manage risks and tax implications. Regularly reviewing and adjusting the plan as your child grows and your financial situation evolves is also essential.

A financial advisor can provide tailored advice based on specific goals and risk tolerance. They can assist in selecting the right investment options. When choosing a financial advisor, look for someone with experience in family financial planning and a good understanding of the specific needs and challenges of investing for children. This along with your tax accountant, careful tax planning can therefore be achieved.

By Gregory Atamian JJN Associates – Accountants Tax Advisors

The content and the references made in this article are correct as at the publication date and are for general information and should not be relied upon as advice. If you wish to seek particular advice, call us on 02 9997 4000.

LEGISLATIVE REFERENCES

Income Tax Assessment Act 1936

Treasury Laws Amendment (Personal Income Tax Plan) Bill 2018 [Provisions]