There aren’t many of us that have children that do not want the best for them, especially when it comes to the opportunities they have as young adults. There is no bigger creator of opportunities than education. Hence, for many people with children a common goal is funding that education when the time comes, whether that be in primary school, high school or university.
The foundation of any strategy where we need funds to meet a future financial goal is to save. Better yet, it is to invest those savings in appropriate assets to achieve compounding returns. In doing so, we achieve our goals more easily.
By implementing a regular investment plan as a strategy to fund a child’s education you are, in effect, paying for that education now with far less effort and stress compared with coming up with what can be a significant sum of money later.
Also ever present and ultimately undermining our ability to achieve that goal is of course tax! For those who have had the discipline and foresight to invest in their child’s education, an afterthought is often the structure of the investment for tax purposes.
The default is often to invest in your own name. This can be ok in some circumstances but for individuals on incomes in higher tax brackets, tax can quickly erode the investment gains. Not to mention, it is far too easy to treat the investment as your own money rather than your children’s.
So, other than your own name what are your options?
Joint names
You could open an account in the joint name of you and your spouse. For tax purposes, this would split the income between both people. However, any tax benefit in this instance still relies on both people having taxable incomes that are not in the top tax brackets. Even though the income is split it is still fixed and if someone is otherwise earning a high income, then any gains from their education investment will be taxed at that higher rate.
Family Trust (Discretionary Trust)
Another option is to hold the investment in a family trust. In doing so, you have the ability to distribute the income amongst beneficiaries (i.e. spouses, children, parents) in varying proportions from year to year. This means that in a year where one spouse has higher income you can distribute the income to the spouse with the lower income. Or if you have family members on lower incomes such as siblings or self-funded retired parents (no government pension), you can potentially distribute to them to save tax. Unfortunately, your children (the very ones you are saving for!) carry certain restrictions if they are under 18. The rules here limit distributions to $416 per child before they are hit with a 47% tax rate!
The tax savings in this situation rely on you having people to distribute to that are on lower tax rates. So, if at the end of the day, it’s just you and your spouse and you are both on higher incomes for the foreseeable future, then a trust might not be very effective. This is especially so when you start to factor in some of the costs of maintaining a trust (e.g. tax return preparation).
A Company
You could set up a company to act as an investment vehicle to hold your investments. In the same vein as a trust, this may provide you with some flexibility in distributing income if structured the right way. A company can also limit the tax you pay as it attracts a fixed rate of tax of 30%. However, for investments that appreciate in value (i.e. the ones we want!) a major problem is that, unlike trusts and individuals, a company does not receive the capital gains tax discount of 50% for investments held longer than 12 months. This attractive benefit not available to companies is often why a company structure is ruled out as an investment vehicle in most cases.
Also, like a trust, there are ongoing costs to consider in managing a company.
A combination?
There may also be a combination of the above that may work for your specific circumstances. This can only be determined through comprehensive tax and financial advice so is outside the scope of this article, but even then, keeping things simple is important. The costs of these such structures can quickly outweigh the benefits.
Insurance Bonds
That brings us to another, little-known option (but not really a secret). An insurance bond, also known as an investment bond, is an insurance-related investment vehicle governed by life insurance legislation.
Think of it a bit like a life insurance policy, except it doesn’t just pay out when you die. It can be accessed at any time and comes with some tax advantages in keeping your funds in it for the long term.
For tax purposes, it operates a bit like a company in that it has an effective tax rate of 30% (and can often be lower) in any given year. However, it also comes with some other benefits including:
- If you hold the bond for greater than 10 years, there is no further tax to pay above 30%. So, unlike receiving company dividends that require you to pay more tax if your individual tax rate is higher than 30%, after 10 years, there is no further tax to pay on income or gains from the investment.
- You can transfer the bond to other people without any capital gains tax consequences. This is helpful if you decide that the funds are to go to a different person than originally contemplated (eg. the better-behaved child!)
- No tax reporting – no tax returns and other associated costs.
- Can be structured around your wishes to ensure that it goes to the intended purpose and recipient if you die.
- Protected against bankruptcy – if you are in business or exposed to other risks, then the bond is protected against creditors.
The types of investments that you can hold within an investment bond are generally limited to managed funds. However, for a regular investment strategy these are the types of investments you might ordinarily want to hold. In this instance a broad range of investment options is generally not seen as a downside and there will be enough available to meet most people’s needs.
In Summary
There are many ways to invest for a goal but for those with higher incomes, insurance bonds have several benefits well suited for saving for a child’s education. Not least of all, better tax outcomes.
See the case study below for an example of how an insurance bond could work in these circumstances.
If you would like to explore insurance bonds as a strategy for funding your child’s education or any other financial goal, please contact us for a consultation.
This article should be read in conjunction with the general information disclaimer found here.
CASE STUDY:
Husband and wife on highest marginal tax rate of 47%
Seeking a tax-effective investment for their son’s private school fees
- $50,000 invested into an Insurance Bond investment.
- $10,000 p.a. regular savings plan established for the first five years.
- Automatic transfer of investment on son’s 25th birthday.
- Ability to leverage the benefit of compounding returns.
- 30% tax offset available on withdrawals in years 6-10.
Scenario
Mary and John intend to send their newborn son Max to a private school (both primary and secondary) and hopefully then on to university.
Objective
Both Mary and John are on the highest personal marginal tax rate of 45% plus 2% Medicare levy and are looking for a tax-effective way of funding Max’s education.
With the rising cost of school fees, Mary and John realise that they need to start planning for school fees sooner rather than later.
Solution
Mary and John set up an insurance bond with an initial investment of $50,000 and an annual regular savings plan amount of $10,000 p.a. for the first five years (before Max starts school).
Mary and John have nominated Max’s 25th birthday for the insurance bond to automatically transfer to Max. The balance of any funds remaining after the payment of school costs will remain in the insurance bond for Max to use.
Benefit
By using an insurance bond, Mary and John can save for Max’s education in a tax-effective manner.
By starting early and utilising a regular savings plan, Mary and John leverage the benefits of compounding returns to help fund Max’s education. Earnings withdrawn in years 6 to 10 will be assessed for tax purposes jointly in their hands, however, both Mary and John will benefit from a 30% tax offset which will be available to reduce any resulting tax liability.
If Max decides not to go on to study at university then the funds can be used for other purposes as they are not specifically required to be used to fund education. Mary and John also have the flexibility to use the funds for any other purpose if their circumstances change.