Your children’s education could be one of the biggest family expenses you face as a parent. Certainly, if you ask anyone who has gone through it, for a number of years your household cash-flow will be severely stretched. It makes absolute sense to plan for these years in advance and if possible, put at least some money aside to ease the burden. There are a number of different ways you can achieve this.
It’s important to start any education plan as early as possible. This will give you much greater flexibility in the types of investments and structures you could choose and also brings the power of compounding returns into play.
Some key things to consider when developing an education strategy is to look at the ownership of the investment, what structure should you use, and in what you should invest.
Whose name should I put the investment in?
Curiously, holding an investment in your child’s name is often the least tax-effective way of saving. Minors are taxed at up to 66%, which is why most parents choose to put investments in their own name (usually the parent on the lower marginal tax rate).
With grandparents often also contributing to education costs nowadays, a decision on the most appropriate ownership structure is one very often made by an extended family unit.
Holding investments in the name of a low income-earning grandparent may sound attractive, but could affect their Age Pension entitlement or other Government benefits. Care needs to be taken to make sure the investment is held in the name of the family member who will be most suitable to hold that investment for the life of the investment.
What investment structure should I use?
Direct shares or managed funds can be good choices for a long-term savings strategy if the marginal tax rate of the owner of the investment is 30% or less, however things can get a bit tricky if both parents are paying high marginal rates of tax.
Income tax payable by those on a high marginal tax rate will reduce the total annual return of any income yielding investment. This in turn can severely hamper the compounding effect of your investment over a number of years.
That said, if the shares or managed fund that you’ve invested in performs very well, then you may not mind paying a higher proportion of your earnings in tax.
Using a managed fund also allows you to make small but regular contributions or a monthly or even weekly basis.
Then there are education or scholarship plans, where your regular contributions are locked away for an agreed number of years, usually until your child starts school.
There are only a few of these plans still available and while some level of tax relief may apply, these schemes are generally quite restrictive and may involve unattractive “catches”. For example, the proceeds may only be released to only cover secondary education costs which may pose a problem if your child wins a scholarship or, in the end, you decide to go public. Further, you may also be limited to quite conservative investment strategies which may not suit a lot of people.
Another alternative that has been around for many years and is still available is the insurance bond. Insurance bonds are essentially a managed fund, but use a different tax structure. They can be a much more tax-effective option when both parents are on marginal tax rates of 30% or more.
Not only can they be set-up in your child’s name, the investment earnings don’t have to be included in the owner’s tax return so high marginal or punitive child tax rates do not apply.
This is because any tax on investment earnings and realised capital gains are paid by the issuer of the bond at the company tax rate of 30% (or even lower if the bond receives any dividend imputation credits).
The real benefit in a bond though, is that if the bond is held for 10 years or more, no capital gains tax is payable when the investment is redeemed. It’s easy to see why insurance bonds have again become a very attractive long-term savings option for parents.
The final option for some is to invest in your own mortgage. For many with a mortgage whose cash-flow is sufficient to put a little extra aside each month for an education fund, perhaps getting ahead in the mortgage will allow you a period of “going backwards” while your child is at school. This strategy provides a guaranteed tax-free return equivalent to your prevailing mortgage interest rate and can be a great strategy. Especially for those with a withering mortgage debt it may be the obvious answer. But a word of caution, this approach does require extra discipline and is probably not for those who might be tempted to spend the little extra you have put aside on that long dreamed about family trip to Hawaii!
What should I invest in?
There are a number of things you must consider to help determine what investment or mix of investments might be appropriate, whether it be direct shares, managed funds, deposits etc. These include how much you can afford to invest initially and each month, how much money you will need at the end, how long before you will need it and what rate of return you need to achieve to reach that savings goal. You will also need to consider your appetite for investment risk and the flexibility you require.
Like anything important, you need to sit down and develop a thorough plan if you want your goal to become a reality. Many people are able to do it themselves, but for those who are not so sure, a good financial adviser can help you not only choose the most suitable ownership and investment structure, but also appropriate underlying investments. The right education plan will help ensure you can provide your children with the best education you can.
RI Advice Group Pty Limited ABN 23 001 774 125, AFSL 238429. This editorial does not consider your personal circumstances and is general advice only. You should not act on the information provided without first obtaining professional financial advice specific to your circumstances. The taxation information contained in this editorial is provided as a guide only and should not be relied upon. You should seek independent tax advice from a qualified tax adviser.