Home Saving Three Things You Really Need to Know When Saving and Investing For Your Child

Three Things You Really Need to Know When Saving and Investing For Your Child

written by Shelley Marsh 03/04/2013

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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If you liked this post you might also like:

5 Financial Tips You Need To Know Now You’re a Parent

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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.

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19 comments

Elise @mummy hearts money 08/05/2013 at 9:43 pm

Great post, I had no idea about the tax rate for minors past the initial $417 earnings, its definately food for thoughts as my kids bank balances start to gradually increase

Reply
Money Mummy 09/05/2013 at 7:32 am

Hi Elise, glad you found the post useful. It is definitely something to keep an eye on and I don’t think it is widely known. Thanks for being my first comment on my blog site! You made my day! Money Mummy.

Reply
Liz 26/05/2013 at 3:47 pm

Wow that it a huge tax rate! I have savings accounts for each of my children. Perhaps I should think about pooling that all into one investment account in my own name for them.

Reply
Money Mummy 26/05/2013 at 6:50 pm

Hi Liz, check how much interest each child is earning, if it is below $417 per financial year then you are in the tax free zone and don’t have to worry. If they earn more than that in interest then it might pay to rethink your strategy. It is definitely something to keep an eye on and if you have concerns see your accountant or financial planner. Money Mummy

Reply
Zona 27/05/2013 at 10:38 am

Thanks mummy money for these tips. However, I am still a bit confused about what can be done to save for my child. I understand that parents funnelling money away to avoid tax had discredited parents with genuine intentions of giving their child a good start for their adult life – but what type of bank accounts do you recommend this scenario for compounding interest?

Is the example in the child’s name or mine/parent?

Does starting a trust fund or fixed deposit make a difference? Ta

Reply
Money Mummy 27/05/2013 at 9:37 pm

Hi Zona, in the post the tax rates I talk about apply to investments made in a child’s name (not in the parents name) – investments like term deposits, bank accounts, managed funds, distributions from a trust, shares etc are all treated the same – the first $417 in income is tax free but after that the income is taxed heavily. Have a look at my investing basics series – this steps you through some of the things to think about when finding the right investments to suit you. You might find Invesment Basics Number 4 useful it is titled “What are my investment options” – this one talks about cash and gives some comparison sites to help you find the best interest deal for your children. Hope this helps. Money Mummy

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veggie mama 27/05/2013 at 11:40 am

Thank you so much for this! I am clueless when it comes to long-term money management, but I really want to get it right for my family. So helpful!

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Money Mummy 27/05/2013 at 9:24 pm

Hi Veggie Mamma! I am so glad you enjoyed my post and found it helpful. There will be plenty more to come. Money Mummy

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Alison at The Thrifty Issue 28/05/2013 at 2:16 pm

Very interesting Money Mummy … certainly food for thought as the only savings we currently have for our children are the piggy banks in their bedrooms! Needless to say, those little piggies don’t hold a lot of money! Have made a note to include them in our budget, and set up a savings account (as per your tips). Cheers, Alison ** Lovely to meet you today!

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Money Mummy 29/05/2013 at 3:29 pm

Hi Alison, so glad you found the post useful. It was great to chat and I look forward to doing some guest posts for your blog. Thanks Money Mummy

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Winnie @ Bubfriendly 31/05/2013 at 6:18 pm

Fantastic post and info! All these things I do not know before! Think I gotta speak to my accountant again before making any sort of investment plan for our children. Thanks for sharing!

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Money Mummy 31/05/2013 at 9:22 pm

Hi Winnie – I am excited to have the opportunity to share my knowledge with you. Feel free to share my article with your friends. Make sure you sign up to my subscribers page so you get all my posts. Thanks Money Mummy

Reply
Money Mummy's Top Tax Tips 17/07/2013 at 4:13 pm

[…] (7)    Make sure that any investments or savings you have are in the name of the spouse paying the lowest tax rate.  This is because dividends and interest are taxed at your marginal tax rate.  Watch out for investments in the names of your children as they may attract punitive tax rates as explained in my previous post “Three things you really need to know when saving and investing for your child” […]

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bec 12/08/2013 at 3:05 pm

I looked into how I was going to pay for private schooling, and we came up against all this type of info, so we decided the smartest thing to do (apart from actually having the cash up front) is to put the extra into our fortnightly mortgage repayment and redraw when fees come up. Apparantly this way we will save in interest we would have paid on the mortgage, so even when we withdraw the extra money, it has already reduced our mortgage, even if it is only a little. (redraw facility on our mortgage is either very cheap or free, can’t remember at this point).

Reply
Shelley Marsh 13/08/2013 at 9:13 am

Hi Bec – yes putting extra repayments on your mortgage can be an excellent strategy and one that is often overlooked. I have been meaning to write on this for a while so thanks for reminding me to do so. Money Mummy.

Reply
Saving For Your Child's Education 06/08/2014 at 6:17 am

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