In the lead up to Christmas, we have been reviewing how you can invest on behalf of your kids or grandchildren. Last week, we looked at buying shares, kids’ bank accounts and tax issues for minors.
In this second part, we look at two indirect investment options – insurance bonds and education savings plans.
But before this, a brief comment on CommSec Pocket which we didn’t cover last week. This is a micro-investing app that makes investing very accessible by having a minimum investment size of just $50 and brokerage of $2. With Pocket, you can invest in 7 exchange traded funds (ETFs) – for example iShares IOZ (which tracks the S&P/ASX 200) or BetaShares NDQ (which tracks the NASDAQ 100). You can set up a regular investment plan where Pocket is on autopilot to invest an amount every month (or other period you determine). For kids and grandkids, this can be a great way to build a nest egg over time.
While investing in ETFs is good for risk diversification, they are arguably not as “educational” as individual shares. Another consideration is that you must have a Commonwealth Bank account to use the app, which depending on the age of your child or grandchild, could cause some issues.
Now, onto insurance bonds and education savings plans.
What is an insurance/investment bond?
Insurance bonds (also called investment bonds) are long term investment vehicles that offer tax efficiency for some investors. While technically incorporating a life insurance element, they are tax paid investments that focus on wealth creation by investing in single asset (eg. ‘Australian shares’) or multiple asset classes (eg. ‘balanced’).
Insurance bonds are designed to be held for at least 10 years. The issuer of the bond pays tax on the earnings of the underlying investments at the corporate tax rate of 30%, which under a special tax rule, means that the investor does not need to include any investment earnings in his or her tax return. After 10 years, the investor can redeem the insurance bond and won’t be liable for any capital gains tax.
If the investor chooses to redeem the insurance bond before 10 years, he or she is required to pay tax on the earnings of the bond at their marginal tax rate, less a tax offset of 30% to reflect the tax the issuer has already paid. If the bond is redeemed during the 9th or 10th year, transitional provisions apply.
One additional rule (known as the ‘125%’ rule) makes them attractive as savings vehicles. Under this rule, investors can make additional contributions up to 125% of the previous year’s contribution with the benefit of these contributions being treated as if they were invested at the same time as the original investment. For example, if you invested $1,000 to start an insurance bond, you could invest a further $1,250 in year 2 and a further $1,562.50 in year 3 and have, for tax purposes, the same 10-year term expiry being the 10th anniversary of the original $1,000.
How do they work for kids or grandchildren?
If the child is 10 years or over, then with parental consent, the investment can be made directly in the child’s name. The minimum investment for some insurance bonds is as little as $500.
Most insurance bonds also include a ‘child advancement policy’. Under this feature, the investment is initially made in your name and at a certain nominated time (known as the ‘vesting age’), the bond is automatically transferred to the child. Vesting does not trigger any tax consequences, and there are usually no fees or charges. The child must initially be under 16 at the time the policy is taken out, and the vesting age can be any age from 10 years to 25 years.
Who issues them?
Insurance bonds are issued by life insurance companies. Five of the major issuers and details of their bonds are detailed below:
Pros and cons
As they are tax paid investments, and you can invest in relatively small starting amounts, they are attractive vehicles for investing for your kids or grandchildren. There are no issues with the minor’s ‘unearned income’ tax and in most cases, the tax paid rate of 30% on an insurance bond is going to be more tax effective than the minor’s tax rate of 45%.
The 10 year investment time frame (minimum) will probably not be an issue for most parents or grandparents considering this alternative. Downsides are the management fee, buy/sell spreads and unlike direct shares, an insurance bond may not be quite as effective in helping your child or grandchild develop an interest in investing.
Choosing an insurance bond
If selecting an insurance bond, look at a ‘growth’ oriented option such as ‘Australian shares’ or ‘growth’ – 10 years is a long time. Management fees also matter. Whilst three of the above issuers incurred the wrath of the Royal Commission, this doesn’t reflect on their ability to manage monies in these products.
Education savings plans
Educations savings plans are designed for saving for tertiary education and can be a tax free way to save.
While they can be accessed to pay for a child’s primary or secondary education expenses, any investment earnings on the savings plan accessed to pay for these education expenses will be treated as taxable income for your child – and potentially be taxed at a minor’s tax rates – up to 66%. However, at age 18, an adult child will enjoy a tax free threshold of $21,594, meaning that investment earnings withdrawn to pay for education expenses will in many cases not incur any tax.
Education savings plans can be set up by a parent or grandparent for a nominated student. Technically, they are classified under the Income Tax Act as a ‘scholarship plan’. This means that they are tax paid investments (the fund pays tax at 30% on any investment earnings), and when those investment earnings are withdrawn to pay for approved education expenses, the tax the fund has paid is refunded to you in full.
Effectively, the fund’s investment earnings, if used to pay for approved education expenses, are tax free. Education expenses include tuition fees, uniform costs, books and living away from home allowance (the latter up to $8,200 pa).
The potential downside is that those same investment earnings, when withdrawn to pay for educational expenses, are treated as taxable income for your child.
Lifeplan Education Bond from Australian Unity
The ‘Lifeplan Education Bond’ is one of 2 education savings plans in Australia (the other is provided by ASG, now called Futurity Investment Group Ltd). Lifeplan is part of the Australian Unity Group and offers plans with 15 different investment options. The initial contribution starts at just $1,000.
Every Lifeplan Education Bond comprises two components. The ‘Investor Contributions’ account records the balance of investor contributions and can be withdrawn (tax free) at any time for any purpose.
The second component represents the ‘Education Benefit’. This comprises the ’investor earnings account’ (that is, the earnings on the investor contributions), plus the ‘education tax benefit’. The tax benefit is only available when investor earnings are withdrawn to pay for educational expenses and can be worth an additional $30 for every $70 of earnings withdrawn.
If the earnings are not used for education purposes, the plan is treated like an insurance bond for taxation purposes (see above). If the plan had been in place for more than 10 years, withdrawal proceeds are not taxable.
Management fees on the 15 options vary between 0.95% pa for a cash option to 1.77% pa and are typically around 1.65% pa.
Be careful with education savings plans
Education savings plans haven’t been very successful in Australia because they are complex, and only work well from a taxation perspective if your child/grandchild is going on to university. With management fees on the higher side, they are not good vehicles to save for education expenses for a child under 18.
As a ‘set and forget’ investment, they are okay – you just need a long time horizon for your child/grandchild.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.