While investing on behalf of your child is a rather complex area, considering that your child is probably not earning an income and that any investments cannot be held in a child’s name, starting at an early age is incredibly beneficial. For starters, it provides some room for greater risk-taking and greater returns, and it allows the earnings to compound for years as the profits are reinvested year after year before your son or daughter can access the funds at the age of 18 years or over.
When choosing to invest for your child, there are a few things to keep in mind:
- Taxation for minors
It is not a good idea to invest in your child’s name as there are penalty taxes imposed on minors. Governments usually impose this taxation to prevent parents from funneling their earnings through their kids’ names for tax evasion.
The penalty tax applies to all forms of “unearned income,” and includes all forms of income where the child is not receiving a payment for a product or service, such as distribution from trusts or interest on share dividends. There is a minimum amount that you can invest in your child’s name. But beyond that figure, you incur heavy taxation.
- Compounding can grow your earnings considerably
One of the biggest advantages of saving early is the ability to leverage the power of compounding. The idea behind compounding is reinvesting all returns (principal + profit) from the previous investment, repeatedly, for the long term – usually over ten years. This strategy works with every kind of investment opportunity, from shares to managed funds to high interest bank accounts.
While you can put in money once and allow it to compound without making subsequent deposits, you can also choose to make extra contributions to increase the principal investment amount starting from a specific point to maximise your earnings at the end of the investment period.
- Education saving plans (ESP) are not necessarily good
While many parents like the idea of education savings plans (ESP), especially because these plans allow you to invest for your child’s education without incurring any tax costs, there are some restrictive conditions that could nullify your efforts.
For instance, some plans allow you to save for your child’s higher education, specifically. But in the event that your child decides against seeking higher education, the plan will only refund the initial contributions that you made, minus the fees and compounded earnings. Moreover, you can only get the full benefit if your child enrols for a full-time program for three years and passes each year of study. This means that you also miss out on the full benefit if your child enrols in a 1 or 2 year course.
There are many other similar plans, so it is important that you read and understand the full Product Disclosure Statement before investing on such products.
You can also choose to opt for bare trusts that allow the child beneficiary to access the funds after their 18th birthday, but still allow the trustee to manage the investment (even withdraw) provided it benefits the beneficiary directly.