Saving for Children: Getting Right

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Saving for children

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

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“.

fi australia

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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