Saving for Children: Getting Right

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It costs one billion dollars to raise each child.  Parents need to start saving for children for private school fees before you leave school themselves. 

Just kidding!  The figures quoted online about how much it costs to raise a child can put you off even trying to save!

Children certainly can be expensive.  But the essentials, love and wonderful experiences can be very cheap. 

Families in all walks of life raise children that are loved, balanced and have everything they need.  It’s preposterous to suggest it has to cost tens of thousand of dollars per year.    

But many parents in a privileged position want to give their children a head start.  Private school, tertiary education and first home deposits are all substantial costs.

A better way to look at saving for children is with optimism.  You have a full 18 years until they potentially start tertiary education or buy their first home. 

For those that wish to help financially with these goals, the gloriously long time frame means compound interest is a super power on your side.   Relatively small amounts sacrificed to savings can deliver out-sized results over so many years.

Saving for Children: What is Your Current Financial Situation?

Whenever setting a new goal, it is important to assess your current situation.  Perhaps you are expecting your child in the next few months?  A more urgent requirement to fund your parental leave will need to be planned out first. 

How long a parent is staying away from work, and whether both parents will work full-time will need to be planned ahead.  Plans and circumstances can of course change. 

Do you have any spare cash or are you just going to scraping by as is? 

Many will have to delay saving for children until both parents are back to work.  Don’t fret if this is the case, just make a plan and set a reminder to start saving with your first pay cheque. 

When your children move from childcare to school, cash flow is often freed up (even with private school) and this is another great opportunity to increase savings. 

If you think you will be able to manage on the income you +/- partner will receive after the baby is born and you will be eligible for the paid parental leave from the government this can be used as a great starter fund.

$753.90 pre-tax for 18 weeks is available for mothers or adoptive parent earning less than $150,000 the financial year before birth.

This is a massive help for mothers not eligible for paid parental leave through their employer, but unfortunately does disadvantage families with a primary earning female. 

Fathers can be earning $1M+ and the mother remains eligible for paid parental leave as long as she earns $150,000.  Mothers can earn $151,000 with a non-working partner and be ineligible for the payment. 

Assuming a 37% tax rate,  this is over $8500 in total post tax.  It’s an ideal starter fund.

A common error in getting excited about saving for children is to neglect to ensure you’re on track for retirement first. 

It would be terrible in a decade or two to fund your child’s tertiary education, but then resent having to work extra years after you’re psychologically ready to retire.

For those lucky enough to have surplus cash, a little extra into the superannuation of the parent taking leave may be your best move.

Saving for Children: What Are Your Goals?

– Private School

There are some terrifyingly high fees charged for private education. Unfortunately there are also less years available to save for this goal. 

Consider carefully whether your child will really receive the value from a fancy school (over more time with their parents) before committing to these huge expenses.

If you find the fees more onerous than you had imagined, you will likely to reluctant to uproot your child if they have settled in well and made friends.

Buying or renting in a great catchment area can be a better option (depending on property prices)!   

Fees tend to increase in secondary school, so this is a common savings goal for new parents. 

You can find school fees for the school(s) you are considering on their websites.  Work out how much it will cost per child and calculate your savings goals accordingly.

One strategy the Aussie Doc family have found useful is to maintain saving the freed up costs from daycare fees when our kids started school.  They do attend a private school, but a reasonably priced one.

– Tertiary education

Tertiary education is a great long-term goal, but no new parents realistically have any idea whether their child will want or need it. 

Many parents choose to save as if the child is going to attend tertiary education, but use the savings for a house deposit or other start up fund if the children choose not to go.

It is difficult to estimate costs for tertiary education.  They will obviously change over the next 18 years, and have been increasing at above inflation level. 

Children can always borrow to fund their studies, so it is not essential to have all (or any) of the fees saved.  Whatever you have saved for them will be a generous gift.

I started by looking at my local university fees, assumed each child would attend medical school (worse case scenario fee wise I think) and set my savings goals to achieve covering these inflation adjusted fees in 18 years time. 

I’m hoping our fund will cover their tertiary education fees and maybe some extra (assuming they don’t both go to medical school) to fund living costs. 

Most importantly, I hope to give them a gift of a financial education, and the option to invest their fee savings to start their investment journeys.

– House Deposit or Start up Fund

With Australian house prices escalating by the year, many new parents worry about their offsprings’ ability to purchase a home one day. 

Helping your children to afford their first home is a wonderful thought, but doesn’t have to be financially burdensome. 

Becoming guarantor for your child will cost nothing (or a small amount of fees) but allow them to skip a decade of saving a deposit.

Your kids will need to prove a good savings ability to the bank before being approved for a loan. 

Gifting everything to children without them having to work hard and learn themselves, I think has been well proven to be a terrible idea.  

Tertiary education costs saved but not used, however can be used to start a home deposit or starter investment fund or business. 

If your child will not handle these funds effectively, they may be best redirected to your retirement savings! 

Few 20 year olds can realistically handle large sums of money without significant financial education over many years prior. 

– Inheritance

Hopefully the reader will live to a ripe old age! 

Your children will, if things go according to plan, be at least into their 60s by the time you die. 

An inheritance in your 50’s or 60’s I’m sure will be gratefully received, if you choose to bequeath it.

But it has nowhere near the potential of smaller gifts in your 20s, when it can be invested for compounding growth for decades before retirement.  Many 20 somethings have blown an inheritance however.

In your child’s 30’s they have hopefully developed more maturity, financial literacy and perhaps large expenses with home ownership and starting a family.  

Starting an investment for grandchildrens education is yet another time to help your kids out.

The best timing for a financial gift probably depends very much on the individual child and how they will handle their money at that time of life.  The best gift of all is to teach them how to grow their own money by learning to “invest like a girl“.

Saving for Children: Taxation

The government are keen to make sure parents aren’t hiding their savings and earning interest tax-free in their child’s name.

Tax on your child under 18’s interest or dividends is therefore 66% (yes that’s correct!) on interest/dividends earned between $417 and $1307 per year.

You should actively avoid breaching this limit obviously. 

Income from employment is considered exempted income and is taxed at adult rates. 

$417 annual income is hard to earn in children’s bank accounts, but if you are investing in shares in your child’s name it is likely you will breach this limit fairly quickly.  

If your child will earn more than $120 / year you will need to apply for a tax file number on their behalf in order to stop tax being withheld and needing to submit a tax return.

Discretionary (Family) Trust

Discretionary trusts are a way to structure your investments.  Trusts come with advantages for

–              Asset protection (especially if both parents “at risk” occupations)

–              Income can be split amongst adult beneficiaries reducing tax burden

–              May offer some protection from future divorce settlements for beneficiaries

–              Don’t have a preservation age

Disadvantages of discretionary trusts

–              Involve setting up fees ($2000-3000) and annual fees ($1000-2000)

–              Can be taken into account in beneficiary divorce settlements and assets outside trust used to compensate

–              All income must be distributed (and taxed)

–              Losses cannot be claimed against other incomes (can’t negative gear)

Assets within discretionary tests have to be distributed to beneficiaries when the trust ends, in 80 years. This may cause a potentially large taxable event.

Special Disability Trust

If you have a disabled child, look into and get independent advise about benefits of a Special Disability TrustThis article on the special disability trust gives quite a lot of detailed information and seems a good starting point.  If you think your family are eligible and it sounds appropriate, these are complex arrangements and would require independent financial and taxation advise.

Saving and Investing for Children: Options Available

Childrens’ Bank Accounts vs Home Loan Offset

There are no current children’s bank accounts paying interest that beats interest rates saved in a owner occupier mortgage offset. 

If you have a mortgage, your offset is likely the best place to save for children’s school and kindy fees.

At times, you can get better interest rates with childrens’ bank accounts.  A quick google search will help you identify the best deals each year. 

A few years, I opened a bankwest account paying 5% and CUA account paying 3.75%.  These accounts often have multiple conditions to meet each month to qualify for the interest. 

Aussie Doc has devised a complex system where savings circulate between the kids’ savings accounts and mortgage offset to meet all the conditions and earn (as Barefoot would say) a bee dick’s more interest.  I like to beat the system (queue evil laugh) and overthink things.

Interest rates however change, even after you have the account set up, meaning it’s not a set and forget strategy.  You need to check the interest paid at least annually and potentially open different accounts to continue to get a better deal than your mortgage offset.  For the sane, it’s usually not worth the hassle.

Your home loan with 100% offset account is an ideal way to save for next year’s school fees and for longer term savings for those with a low risk tolerance, or if interest rates increase.

Investing in Shares for Children

With such a long-time frame, investing in the share market is an option for saving for children for secondary school, tertiary education, home deposit or starter fund. 

Options include an ETF or index, listed investment company eg AFIC, or an insurance/ education bond.

ETFs and Index Funds

ETFs are brought via the ASX, using a broker such as Commsec, Selfwealth or Pearler

Commission fees are charged to buy and sell.  This can be expensive if you are buying in small parcels (for example with each pay). 

ETF management fees are generally cheaper than index funds. 

Index funds are purchased without commission fees but annual fees are higher and there is usually a minimum starting amount associated with index funds (but not ETFs).

Selecting funds themselves can cause long term procrastination, however.  If you are interested in investing and want to design your own portfolio, immerse yourself in research for a limited amount of time, make the decision, write a plan and stick with it.

Alternatively, you could ask a carefully chosen independent financial adviser to design a portfolio.

Robo-advisers are the easiest way to start investing with tiny amounts if you just want to get started, but due to the extra layer of fees on top of the underlying fund fees (from 0.26% extra) they are not the cheapest way to invest long-term. 

These fees seem tiny to begin with, but compound to significant amounts over the years. 

Having said that, they are a great way to get over the procrastination while you work out if the funds suggested by the robo-adviser are what you want to invest in long-term.

Remember, if you wish to sell the funds from your robo-adviser account and invest in funds independently, you will need to pay tax on any capital gains.

Some robo-advisers allow you to label some or all of your investments for children, although for taxation purposes the shares are considered owned by the adult opening the account.

Listed Investment Companies (LICs)

LICs are actively managed fund with fees almost as low as those for an ETF. 

They only cover the Australian market, so are not diversified enough to make up your entire portfolio. 

Australian Financial Investment Company (AFIC) and Whitefield LICs allow “Dividend substitution”. 

This means, instead of receiving dividends (with franking credits) and paying tax on that income now, the company provides you with an equivalent amount of extra shares and defer taxation. 

This results in capital gains tax eventually (discounted 50%) and if withdrawals can be timed when you are on a lower marginal tax can be advantageous for high income earners.       

Insurance and Education Bonds.

These are more complex products, aimed at high income earners.  Both are associated with higher fees and have a history of under-performing the index, so I would only consider if both my partner and I were on the top marginal rate of 47%.

There are complex rules associated, and the fees associated need to be examined carefully. 

They generally have tax benefits if the investments are withdrawn out after 10 years, with investment bonds paying tax at a company rate (30%) but eligible for the 50% capital gains discount that individuals benefit from. 

Earnings from education bonds are again taxed at company rate (30%) but if earnings are withdrawn after 10 years for education purposes (including books, uniforms, rent at university and HELP fees), this tax is refunded to the investor. 

This potentially tax free return sound enticing, and I did open one a few years ago.  The fees are a major drag again, with Australian Unity’s life plan education fund charging 1.73% management fees and requiring a financial adviser to open the account for you. 

If withdrawals are not used for education costs, tax benefits are lost. As a result, if your children don’t attend tertiary education, you may benefit nothing from tax benefits and all of the high fees.

Case Presentations

Jill & Jane – High Income Couple

John and Jill are both specialists with strong incomes of around $400,000 each. They have two children, aged 3 and 6 High Income single parent/ Double High income.  Both would pay 47% tax on any investment income in their own names.  The kids will pay 66% tax on investment income over $420/year each.  John and Jill save the kids school fees in their mortgage offset saving them 3% interest tax free.  For longer term savings for tertiary education appropriate options would be:

  • Mortgage Offset 6%+
  • LIC inside a family trust for asset protection and ability to distribute income to children once the children turn 18. If the family opt for a LIC that allows dividend substitution (not dividend reinvestment) all income through dividends can be deferred until the children turn 18 and can receive income taxed as capital gains (50% discount once the tax-free threshold has been reached for each beneficiary).  The amount invested would have to compensate for the fees associated with setting up and maintaining the trust. 
  • Education Bond

I calculate that if the education bond fee is 1.73% and LIC management fee 0.3% of invested amount and the cost to maintain the family trust is $2000 annually

Bob & Barry: Moderate Income Household

Bob and Barry are parents of a rambunctious 3 and 6 year old.  They are working full-time for the foreseeable future, earning around $140,000 each.  

Both these parents will pay a marginal rate of 37%. Again, their children will pay a punishing 66% if the earn more than the $420 investment income cut off.

Here their options are

– Mortgage Offset

– Index fund / ETF / LIC without trust

– Education Bond

Low Income Parent 0% Marginal Tax Rate

Susie and Sam are parents of 3 and 6 yr old kids.  Sam is planning to stay at home with the kids for the long-term. 

Sam can earn up to $18,200 in investment income and pay no tax.  The best options for this family are likely to be

  • ETFs/Index funds/LIC without trust
  • Mortgage Offset at 6%+

Their focus should be on building an diversified investment portfolio whilst minimizing fees.  Sam can likely invest up to around $300,000 before he would expect to start paying any tax (depending on investment chosen).

Because of  the absence of taxation (up to to the income threshold), the couple can really take advantage of the higher returns associated with investing directly in a low cost index fund.  In comparison with the high income couple, they are able to accumulated $12,000 if both couples invest $5000 per year for 15 years.

Asset protection should also be considered, but the lower earning spouse is often the lower risk.

How you can best save your children depends on your overall financial picture, goals and marginal tax rates.  Most advantageous options also depend on the amount invested and the time frame.

Use this article and examine your long-term financial position to decide on your best strategy. 

Aussie Doc Freedom is not a financial adviser and does need offer any advise.  Information on this website is purely a description of my experiences and learning.  Please check with your independent financial adviser or accountant before making any changes.

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Best personal finance books

This article may contain affiliate links. If there are any in this article they are marked *. An affiliate link means if you click on the link and purchase a product, at no extra cost to yourself, I will receive a small commission.

Want to learn how to use your salary wisely to invest for a secure future?  Not sure where to start with the overwhelming number of finance books available?

Good news, I think I’ve read most of them!

This article reviews the four I found most valuable.  As a bonus, 3 out of 4 are Australian.

Borrow these four books from your local library if you can.  They provide >90% of the knowledge you will ever need to secure your financial future.

Best Finance Book 1: Rich Dad Poor Dad* – Robert Kiyosaki.

Although one of the most frequently recommended finance books, this author comes with a truckload of controversy!  Multiple lawsuits and bankruptcies over the years although Robert Kiyosaki’s personal wealth remained sheltered.  Perhaps “Rich dad” really didn’t exist, and there may be more fiction than fact in the book.

It was my first finance book, as a resident.  It shocked me with some revelations, which I still value massively in my strategy today.

Powerful Lessons

“I don’t work for money.  Money works for me.” 

It seems odd that this hadn’t occurred to me.  But at the time, there was far no talk about passive income (that I can recall).  The realization that I could choose to spend money on liabilities (cars, holidays, clothes) or assets (real estate, businesses, shares).  This I realised, would define my financial future.  This concept had not really come up before.  I was brought with a traditional view of studying hard, getting a good job (tick) and money wouldn’t be an issue.  Obviously, even good earners need to manage their income effectively.  Although I was not ready to start investing in assets anytime soon, I am glad my main takeaway from this book was to minimise the liabilities I committed to.

You Can Change Your Tax Rate

This was also the time I realised that employees are taxed higher than anybody else.  It seems crazy, but you are actually penalised by earning money through personal effort.  Business and investment income taxation is significantly discounted.  The government want the economy to grow – and businesses and investments help with this.

Your home is not an asset.

Again, I had been taught to buy as much house (in the best street) as you could afford and pay it off.  This book argues that as your home takes money out of your pocket instead of paying you, it is a liability.  15 years later, I really don’t it’s that simple.  Buying an expensive home in a great area can set you up financially.  But it guided me towards buying a more modest home in the regional area in which I worked.  This left cash spare to invest

The Dodgy Bits

The book pushes you to “be bold” and take the road less traveled.  There are a few passing mentions to risk, but this really isn’t examined in detail.

I guess I’m not a big risk taker, but I consider the risk the most important factor to consider when taking on an investment.

The book really encourages readers to take on big risks. Readers don’t need to take big risks, they just need to invest sensibly over a long time frame.

Rich Dad Poor Dad Seminars

These had a lot of bad publicity.  They have charged thousands of dollars.

Now, Robert Kiyosaki sells Rich dad poor dad franchises – for $25,000 USD.

I tend to feel franchises tend to target novices with little idea how to run a business, who often lose out big time.

Now, ambitious young men run these seminars in the hope of getting rich themselves off attendees. Hmmm…

Best Finance Book 2: Barefoot Investor* – Scott Pape

Definitely the most popular Australian finance books.  If you haven’t yet read it, get to it stat!  It’s a quick read – squeezed into an afternoon with ease.

It’s also a lot less dry than most finance books.  The personal stories around Scott’s loss of the family home to fire bring risks to life.

Most doctors have read this book, and many have completely reorganize their finances as a result.  No more overdrawn or account fees!

Particularly powerful parts of the book were:

  • Organizing your money to minimize fees and capture savings effectively

  • Start investing regularly now

  • Specific steps to take to start taking action now.

Parts I didn’t Like:

Scott recommends storing your emergency fund in an outside account (not mortgage offset).

His theory is out of sight out of mind – you are less likely to blow it if it’s in a different bank (even suggesting cutting up the key card and making it challenging to access).

For those who are used to keeping an emergency fund, with some self-control, a mortgage offset account is a far more efficient way to store these savings for home owners.

Savings accounts will maybe earn you 2% interest (which you will then pay tax on).

Offset savings will save you currently ~ 3% off mortgage interest (untaxed).

The book is anti-property. He advises not bothering with property investments and going with shares alone.

Although the book is largely “fiercely independent” he had a vested interest here.  The “Barefoot blueprint” subscription for stock market investment tips has now shut down, but at the time of book publication was marketed within the book.

To be fair, I see his point.  Most people I know have not made money from their property investments, due largely to poor asset selection and lack or research.

But I believe with adequate research and professional assistance, property investments can be the most efficient way to build wealth long term.

Best Finance Book 3: Investopoly* – Stuart Wemyss (2018)

The least well-known book in this list was a random find.  It had great reviews, and has been my most successful impulsive book purchase to date!

I had read a lot of finance books over the years.  Many are claiming a single strategy they used at a point in time can be repeated in different time periods with equal success.

Most are detailed in one strategy or another.  But initially, most of us need a  plan.

My interactions with financial planners so far have not so much as provided a plan, but sold me insurance and only provided information that was going to profit the financial planner in some way.

Stuart Wemyss is a qualified chartered accountant, independent financial advisor and mortgage broker.

The book uses 8 golden rules to take you through designing your financial plan and work out the best strategy to achieve your goals.  I have not found a book so complete and relevant to me as a frustrated investor.

The book strategies timing which investments first (capital growth first, pivoting into income) which made a lot of sense.  Investor examples are provided.

Concepts are explained so simply anyone without financial know how can understand, and I suspect take some nuggets away from this book.

Exactly what the doctor ordered!  And as a bonus, while writing this review, I have discovered they also have a podcast “Investopoly”.

Here is a list of my recommendations of the best finance podcasts.

Best Finance Book 4: An Armchair Guide to Property Investing*

I’ve talked extensively about the help Empower Wealth provided when I brought my 1st investment property. 

This is not a book by a single property investor who made millions as a result of being super aggressive at the right time, in the right market and with a bit of luck.

The Armchair guide was written by the brains behind the buyers’ agency Empower wealth.  They have decades of experience purchasing properties for clients and have worked out reliable methods that provide great opportunity for profits whilst minimizing risk.

If you are interested in investing in property I would suggest subscribing to their podcast.

The book discusses a lot of the important concepts covered by the podcast, but adds more value with 18 investment strategies explained.

Furthermore, it goes through the detail including prices and target growth / yield for property portfolios for 6 case studies – young rentvestor, DINKs (double income no kids), Couple with young kids, couple with older kids, Empty-nesters and divorcee.

Bits I don’t Like

I’m not sure the book provides the information to actually select the assets reliably.  I actually don’t think this is possible in a book so I’ll forgive them.  I suspect asset selection is a skill that experience is vital for.

Don’t really have any other criticisms for the book.  I have read plenty of “Get rich from property” books but nothing with as much useful and specific information as this.

Here I’ve listed what I think are the current best personal finance books.  I believe these books provide a good foundation of important concepts.

Of course, like medicine, learning never ends.

But starting with these carefully selected books that offer the most value initially will get you a lot further in financial literacy than most.  From here, you can decide what you want to learn more about.

Happy reading!

Aussie Doc Freedom is not a financial adviser and does need offer any advise.  Information on this website is purely a description of my experiences and learning.  Please check with your independent financial adviser or accountant before making any changes.

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How and Where to Invest Your Savings Now

This article may contain affiliate links. If there are any in this article they are marked *. An affiliate link means if you click on the link and purchase a product, at no extra cost to yourself, I will receive a small commission.

Are there any perfectionists among readers of this blog?  Perfectionism is a useful trait in medicine.  But it can cause indefinite procrastination when deciding how to invest. 

If you want to improve your financial situation, you need a plan.  No plan will be perfect, but it will give you a direction to start.   Goals can  be changed, and plans altered.    

There are three main ways to make a plan:

1. FIND A TRUSTED ADVISER

You will need to research a trustworthy adviser.  A retirement age, income and other goals need to to be decided.

2. MAKE YOUR OWN PLAN Again, you will start with setting goals, then work out a strategy of how to achieve those goals

3. START INVESTING NOW and work it out later

Investing without a plan risks needing to change course later.   You will pay capital gains tax on any profits if you sell to move investments.

But keeping your cash in a bank account is losing you real money due to the effect of inflation.  Once you have an emergency fund, men and women need to learn to “invest like a girl“.

But if you have no idea about goals, making a 40-year plan can feel overwhelming.  It’s better to get started than procrastinate indefinitely. 

Small amounts invested regularly over a long time accumulates wealth.  The power of compound interest is incredible.  Investing $100 weekly from age 20 results in $1.146 million dollars by age 60 (assuming 7% Growth)! 

A simple savings calculator for calculating your savings goals can be found at Money smart.  An arbitrary goal to save, for example, an additional million dollars in superannuation is better than none.  You can perfect the plan later when your goals become clearer.

How and Where to Invest: Set a Goal, Time Frame and Strategy

Once you have a goal, calculate the target you need to accumulate within your timeframe.  Next, it’s time to consider broad strategy, before getting into individual investments:

  1. Invest inside or outside superannuation
  2. Invest for capital gains or income
  3. Taxation considerations
  4. Choice of Assets & Asset allocation

How and where to invest your savings: Inside or Outside Superannuation

– Inside Superannuation

Superannuation compels employees to save for retirement.  It obliges you to build wealth through compound interest over your long career. 

Super locks savings away until preservation age (currently 60yo).  This illiquidity is generally considered a disadvantage.  However, it protects investments from impulsive withdrawals.  Failure to stay the course is the biggest risk for most!  

Many employers will allow salary sacrificing into superannuation.  Other (such as self-employed individuals) can tax deduct their superannuation, with the same results. 

Contributions into superannuation are taxed at only 15% assuming gross earnings <$250,000.  This is far lower than most people’s “Marginal tax rate,” saving lots of tax. 

A worker earning $70K salary sacrificing $115 into super will only be ~$78/week out of pocket.

 

The graph has not taken into account taxation of dividends, which will worsen the higher tax situations.  After retirement, your superannuation can be converted to a tax-free income stream. 

If you (and your partner) earn more than $18,200 annually, investing a little extra into your superannuation is a no-brainer up until you earn ~$250,000. 

– Investing Outside Superannuation

There are a couple of situations in which you are better off investing outside super.

  1. If you intend to retire before the preservation age (whatever it will be at the time). The preservation age is the age you can withdraw super tax free (currently 60).  If you want to retire earlier, invest some outside super to bridge the gap until you hit the preservation age.

 

  1. If you (or partner) will earn less than the $18,200 annually over the long term. In this case, investing in the non (or minimally) earning spouse can result in tax free growth.  You could expect to invest around $300,000 in a before paying tax on dividends.

    

  1. If wanting to purchase property as an investment. Borrowing money within a Self-managed superannuation fund usually results in less leverage, higher interest rates, large fees and lots of hassle.  Growth (negatively geared) properties provides tax benefits for the high-income earner.  Rental income from a positively geared property can be tax free if earning less than $18200.     

After retirement, most will aim for around $18200 or less income per person outside of superannuation in order to minimize taxation. 

 

How and where to invest your savings: Capital Growth or Income Assets

– Investing for Capital Growth

Capital growth investing relies on an increase in value of an asset over time.  Income produced at the time of purchase is not a priority, in fact the investment can cost you money each year initially. 

Capital growth investors expect investments to produce a good income stream over the long term.  This income can result from increasing yield over time, or sale of assets. 

A high earning professional may choose to buy an investment property with good capital growth potential.  Capital growth and yield (net rent) tend to be inversely correlated. 

Rent received on a capital growth property will be inadequate to cover mortgage interest and other costs of ownership.  So, the investment will produce a negative yield overall.  High earners tolerate this because they are focused on creating an income stream only when they retire.  

Tax refunds compensate partly for the lost income, making this a tax efficient investment, as long as the capital growth eventually occurs.  

The capital growth strategy can also be used when investing in the stock market.  Warren Buffet’s investment company Berkshire Hathaway famously pays no dividend.  Companies have a choice when they produce a profit.  To use that income to invest back into the business, or pay a dividend to investors. 

A capital growth strategy can sometimes result in a cash flow deficit despite large asset value – especially with property portfolios. 

– Investing for Income

It seems intuitive to invest for income.  Income investors have their eyes on the prize.  Income starts minuscule, but over time grows.   Income investors don’t want to rely on capital growth that isn’t guaranteed.

Income investing will produce some income faster, which gives investors more cash flow security.  

Below is a graph that demonstrates gross income (yield) produced by two properties that deliver consistent 11% total returns annually. 

The yellow line represents a “Yield” property – with returns consisting from 7% yield, 4% capital growth. 

The orange line represents a “growth” property returning 4% yield and 7% capital growth. 

You can see that the yield property produces more income until around year 21, when the capital growth property overtakes.  Both are assumed to be completely un-taxed throughout.

Income investing usually has a lower barrier to entry.  It is often more suited to lower income earners.  Property, shares, bonds and fixed interest can be counted as income investing.

High yield property tend to be cheaper, in more regional areas.  Some can be extremely volatile, especially in one industry towns. 

Everyone was jumping into mining town properties a few years back, encouraged by incredibly high returns from extortionate rents.  With the downturn in mining, these properties often lost half their value and the tenant pool dried up.

A carefully selected income property with carefully screened tenants can produce an income stream that increases with inflation. 

Shares brought for income fall into the “Dividend investing” category.  Certain companies are expected to pay consistent dividends, others focus on capital growth. 

The idea with share income investing is that dividends gradually increase over the years.

Bonds are often included in retiree’s portfolios, due to lower volatility and predictable income.  They are expected to provide a lower return long-term than shares, but more than cash.  Many investors like to transition more into bonds as they age, and capital protection becomes a higher priority than growth.

– Capital Growth vs Income Investing: Timing

Capital growth has the potential to create greater income eventually, but needs a longer time frame. Without enough time, investors can end up “Asset rich, Cash poor”. 

Many investors will benefit from using both strategies, capital growth initially to build a large asset base, before pivoting towards income investing in later years. 

The capital growth experienced initially can be used to leverage into higher value income investments and grow income faster than a pure investing for income strategy. 

I found the book “Investopoly” by Stuart Wemyss* did a good job of explaining a broad strategy to combine growth and income investing efficiently.

How and Where to Invest Your Savings: Taxation Considerations

Take some time to consider your tax position.  Are you (+/- partner) high income earners, expecting to pay increasing tax as your incomes increase?  Is an adult in the household planning to give up work or earn minimally for several years?

Investments should not be made for tax reasons.  Decide on a broad strategy and investments first, then work out how to minimize tax.

Many investors have lost money through investments designed to reduce tax.  It is also illegal to avoid tax or make investment decisions based on taxation.

Dividends are taxed at your marginal rate.  Capital growth is tax free until sold – and discounted by 50% if owned for at least a year.

 Therefore, a tax paying investor may benefit from minimizing dividends paid in order to compound capital growth tax-free until retirement. 

Tax paid at 30% within the company on profits reinvested are more tax efficient than high income earners being paid dividends.

“Franking credits” mean that investors avoiding paying tax twice.  Tax is paid on profit within the company before the dividend is paid. 

A tax (imputation) credit is applied to the dividend so the investor only pays their marginal rate on that dividend.  This means a refund for those paying less than 30% tax, but still produces a tax bill (marginal rate – 30%) for higher income earners. 

Franking credits improve returns for those with a marginal rate less than 30%. 

For higher income earners, Australian Financial Investment Company and Whitefield allow “Dividend substitution” plans – where extra shares are awarded instead of dividends paid, resulting in no tax paid during accumulation period. 

How and Where to Invest Your Savings: Asset Allocation

There are 4 main asset classes – property (residential and commercial), shares, fixed interest (bonds) and cash.  As I said earlier, there is really no ideal asset allocation, but your age and risk tolerance should be carefully considered.  There are several Asset allocation calculators online – including at Bankrate and Smart Asset

I haven’t found one that includes direct property investments.  It’s easier to consider how much property you wish to own at retirement initially, and then work out asset allocations for the rest. 

This may be more aggressive for initial years and transition to a lower volatility portfolio as you near retirement.  It is important to have a written plan of how you plan to invest so that you re-balance your portfolio when your allocations get out of balance.

– Cash

Cash loses purchasing power over time, due to inflation. 

This is the least efficient way to accumulate wealth (ignoring debt!). 

Cash should, however, be kept in an account to cover 3-6 months of essential expenses in case of an emergency.  Self employed persons or those who feel their income is not secure will want to save 6-12 months. Check out my Up bank review to compare the features of Up bank, ME and ING to find the best option for you.  

Any more than this is an opportunity cost.  The cash component puts me off pre-mixed diversified portfolios such as VDCO.  Cash, for me at least, needs to be separate from the rest of my investments in my bank/offset and available immediately when required. 

A bank account will probably pay less than 2% interest, so offsetting this cash against your home mortgage is the ideal way to maximize your return tax free.

– Fixed interest

Term deposits (AKA Certificate of deposit) lock up your cash for a defined period of time, and return a set interest rate (currently extremely low).  I would consider buying a term deposit for if interest rates became incredibly high, but can’t see any benefit at current rates.

Bonds can be brought directly via the ASX, in a bond ETF such as Vanguard VGB or Ishare IAF.  You likely own some in your superannuation.  They have traditionally lower growth and volatility than shares, but higher interest than cash investments.  They are intended to provide a more stable income source, and to reduce risk and volatility. 

Investing in bonds means loaning your money for a fixed period and receiving fixed or “floating” (variable) interest (AKA coupons).  They vary in risk from government bonds (rated AAA) to higher risk bonds for companies or countries that are less credit worthy (rated down to D).  Asset allocation to bonds traditionally increased with age, to lower volatility of your portfolio. 

Prices can fluctuate with changes in interest rate, and market expectations of the same.  The ASX has got a great education module on investing in general, but has a good part about bonds.

As with shares, when choosing an investment you should read the prospectuses and compare costs including hidden costs using the Indirect cost ratio

Buy/Sell Spread – How much will you lose when buying and selling due to the difference in prices between the two

Liquidity – How many buyers are there? Will you be able to sell when you need to?

Yield – Is it fixed or floating? How does it compare with other bonds?

Risk – How Credit worthy are the bond issuers?  How confident can you be of getting your initial investment back?

– Property

It appeals to me to have property income to diversify retirement income. 

Watching from the sidelines as a resident doctor in 2008, I realised it would be extremely stressful to have the asset pool from which your only income originates (superannuation) to drop by 50%. 

It is often advised to have 3-5 years in cash saved in retirement in case of such downturns.  That cash can be offset against an investment mortgage at 3-8%.  This return should maintain it’s purchasing power far better than in a bank account earning 1-3%. 

Many property adviser groups encourage going 100% property.  Putting all your eggs in one basket is risky! The biggest issue with well selected property (to me) seems to be legislative risk.  It seems the rules of the game can change quickly and dramatically. 

The Property Couch is a podcast with tons of super valuable content.

– Shares/ Equities

Owning tiny portions of lots of businesses is a great way to build wealth.  Long-term returns have been around 8-9%.  No-one can realistically predict what future returns will be.

Many are scared by the volatility of the stock market.  The value of each share bounces around constantly, with extensive debate as to the causes of the changes and what will happen next.  50% or more of these predictions tend to be wrong!

Passive investing has been shown (particularly through Warren Buffet’s famous bet ) to produce superior results most of the time.  Even great stock pickers struggle to compensate for the fees they charge.  Paying an “assets under management” or management fee of 1% or more rarely leads to a better return than simply investing cheap and passively. 

Index funds or passive ETFs are a great way to start building a diversified portfolio.  Many will continue to use purely these passive investing strategies exclusively.  Others may choose to dabble in individual stocks once they have worked out a strategy they like. 

The ASX (Australian Stock exchange) only accounts for ~4% of the world’s equity markets.  Global asset exposure is an important factor in risk reduction and diversification.  Vanguard suggest an allocation between 50-96% global: Australian equities. 

PassiveinvestingAustralia suggests basing the percentage of your total net worth to correlate with percentage of overseas spending.  Stock spot have listed their top 10 global funds with details on funds and other factors to consider.

Where to Learn More About Share Investing

The ASX website has a great beginners guide to explaining the basics of stocks, bonds and more.  Passive Investing Australia is an incredible website with detailed articles taking you through all you need to know to start choosing investments.

If you don’t have the time and just want to get started, consider starting investing small amounts in a robo-adviser.  You can get started in around ten minutes, and it avoids endless procrastination.

Congratulations on reaching the end of this very long post!  Remember, the most important points are to set some goals and time line (vague is OK if you’re not sure), and START investing.  Good luck!   

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Aussie Doc Freedom is not a financial adviser and does need offer any advise.  Information on this website is purely a description of my experiences and learning.  Please check with your independent financial adviser or accountant before making any changes.

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