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The best time to start saving for your child is now.  Whether it be for their education, or to buy a car or a deposit for a house, having time on your side and a long term investment horizon will help you to your reach your goals.  However, there are three things you really need to know about when investing/saving for your child:

  1. Watch out for the taxman!

Investing directly in your child’s name is unlikely to be the most tax effective way of saving for your child.  This is due to tough penalty taxes for minors.  The Government has put this in place to stop parents funneling money into their children’s names to avoid tax.  The penalty tax is applied to “unearned income”, that is money the child has not worked for and includes income such as interest, share dividends and distributions from trusts.  If you invest under your child’s name, the first $417 of unearned income is tax free but after that tax is charged at 66%!  Any unearned income after $1,308 is taxed at 45%!  The upshot of all of this is that generally speaking, the parent with the lowest tax rate should invest on behalf of the child.

  1. Let compounding do the work for you!

Compounding is one of the best investment strategies of all time and the greatest part is anyone can use it.  The keys to getting compounding to work for you is to reinvest the earnings from your investment and invest for the long term (10 years plus).  This strategy can be used regardless of whether you choose to invest in managed funds, shares or a high interest bank account.  The best way to demonstrate how it works is to look at this simple example:

Scenario 1: You invest on behalf of your child at 10% per annum over 20 years and reinvest all returns

Year Start Value Interest End Value
1 $1,000 $100 $1,100
2 $1,100 $110 $1,210
3 $1,210 $121 $1,331
4 $1,331 $133 $1,464
5 $1,464 $146 $1,611
…….
15 $3,797 $380 $4,177
……
20 $6,116 $612 $6,728
Total interest earned $5,728

 

Scenario 2: You invest on behalf of your child at 10% per annum over twenty years and withdraw all returns.  At the end of the 20 year period you have earned $5,728 in total interest.  This is without making any extra contributions.

Year Start Value Interest End Value
1 $1,000 $100 $1,000
2 $1,000 $100 $1,000
3 $1,000 $100 $1,000
4 $1,000 $100 $1,000
5 $1,000 $100 $1,100
…….
15 $1,000 $100 $1,000
……
20 $1,000 $100 $1,000
Total interest earned $2,000

 

At the end of the period you would have made $2000 in total interest.

In these examples, simply reinvesting without making any extra contributions increases your return by  $3728 over twenty years.

Adding extra contributions, really makes the benefits of compounding take off.  For example, if you started with the same $1,000 invested at 10%, but contributed an additional $20 per month for the 20 years, the final investment would be worth $21,207.  Of that $21,207, $15,407 would be interest income a big step up from just sticking with the initial investment and earning only $5,728 in interest income!

  1. Be wary of education saving plans (ESP)

Education savings plans (ESP), sound attractive as they offer tax free investment for education.  However, like with all investment products it is very important to understand the full terms and conditions that apply to your investment.  For example, with the Australian Scholarships Group’s The Education Fund (TEF) there are very restrictive conditions on access to your investment and its earnings.  Under this plan, if your child decides not go on to higher education, you will only be refunded your initial contributions less fees and you will not receive any compounded investment earnings that would have been earned during the entire time you have been invested.  Also to get the maximum benefit, your child must study full-time for three years and satisfactorily complete each year of study, so if they choose a one or two year course you will miss out on the full benefit.  There are many more terms and conditions on this product so I cannot emphasize enough how important it is to read the full Product Disclosure Statement before making any investment decision on this product or any other.

Armed with these three important strategies I hope you are more informed to make good savings and investing decisions for your children.

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* Please note this is general information only.  Please see your accountant or financial planner for specific advice suitable for your circumstances.

03/04/2013 19 comments
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