Secret to investing for your kids

This was originally published in the Australian on 26 Nov 2021. Click here to access the original.

It is advisable to consult an accountant before setting up a stock account for a minor.

There are few questions more common inside financial planning than “how to invest for the kids”.

It should be easy to answer, and there is a small industry out there putting forward apparently simple solutions.

But let’s focus on what really works rather than what seems to be the most heavily promoted products, which are investment bonds.

Certainly, investment bonds can provide some simplicity of management, but they attract a tax rate of 30 per cent and they come with relatively high ongoing management and investment costs, if you were to compare them to a traditionally low-cost exchange-traded fund.

One of the best kept secrets in this area that ticks the boxes with regard to simplicity, low fees and tax effectiveness is to set up a stockbroking account under a minor trust trading arrangement.

Luke Star, certified practising accountant from Star & Associates, says: “Minors are not able to own assets in Australia in terms of legal ownership but they can beneficially own assets.

“Stockbrokers allow adults to set up accounts with a designation to the child. The adult is the legal owner although the beneficial owner is the child, with the adult effectively holding the shares in trust for the child.”

When the child turns 18, the shares can be transferred to the child’s name. And as there is no change in beneficial ownership of the shares, the transfer is likely to have no capital gains tax implications. This is crucial, as CGT is often perceived as the biggest drawback when aiming to help younger investors get started.

In addition to no CGT when the child turns 18, tax can be managed along the way by understanding the tax rules that apply to minors.

Star says: “The minor tax-free (annual income) threshold is only $416 and over $1307 the rate is 45 per cent of the total income.”

So working to these beneficial ownership rules can result in both a tax-effective and low-cost way to invest for your child/grandchild.

Kieran Neeson, head of retail sales at stockbroking firm Opentrader, says: “The most popular investments for minors are blue chip shares such as BHP, Commonwealth Bank and Telstra, as well as ETFs such as the Australian Shares High Yield ETF, ETFs that track the world’s largest companies, US indices such as the Nasdaq, global property ETFs, and corporate bond ETFs.”

However, we might have an exception here to the so-called “wisdom of crowds” because if you focus on stocks and ETFs that pay little to no dividends – in other words, growth stocks such as CSL or an offshore ETF such as a product focused on the Nasdaq – then as long as you do not sell and just keep accumulating, while the total dividends are less than $416, there will be no tax payable.

Overlaying the tax effectiveness aspect, buying Australian blue chip stocks that pay dividends of 5-7 per cent means if you have more than $8000 in a minor’s share account, your child will probably have an income tax bill.

However, if you invest in growth-based stocks and ETFs such as a US technology ETF that pay minimal dividends, assuming a 1 per cent dividend, you could have $41,600 in the minor’s stock account before income tax would be payable.

And the beauty of the strategy is that when the minor turns 18, they benefit from adult marginal tax rates and, if desired, can use the $18,200 tax-free threshold to effectively start to sell down some of the shares accumulated for them since they were a child. But of course, if they are also working part-time, this will need to be taken into account as part of the $18,200 tax free threshold.

Managing the portfolio

In terms of share trading account costs, generally fees are limited to trading events only and many online stock brokerage firms charge brokerage from as little as $5 a trade.

Neeson says: “The account opening process is very straightforward and is easy to set up. The applicant being the adult and authorised operator simply completes a minor account application and electronically submits that to our team for verification, and the account will be ready to fund shortly thereafter.”

The parent or grandparent can then buy shares periodically and, assuming none are sold and that dividends are below the magic $416 number, no tax is payable year to year. When the minor turns 18, the process to transfer the shares out of the trust arrangement is simple.

Kylie Macdonald, principal at stockbroker Morgans at Mona Vale, says: “A simple off-market transfer form is completed to transfer the shares into the young person’s sole name when they turn 18 and we generally would not charge for this.

“However, some stockbrokers do, so you should check before you set up an account.”

There are a few other things to be aware of, so it is advisable to consult with an accountant before setting up a stock account for a minor.

The tax office does not automatically allocate the income and gains against the child’s name under the beneficial interest ­account. They will consider who provides the money for the share purchases, who makes the share investment decisions, and who receives and spends the dividends.

If these three criteria are not satisfied, the ATO may allocate any gains and income to the adult rather than the child. This may be troublesome, especially if the parent is on a high marginal tax rate, or for a grandparent receiving a means-tested age pension.

However, it is generally accepted that if the money is gifted to the minor and that they participate in investment decisions when age appropriate and dividends are not spent by the adult, the gains and income can be attributed to the minor, rather than the adult.

Neeson says: “One of the greatest benefits in starting an investment account for a minor and contributing to it regularly is that the barriers to entry are exceptionally low, and it’s a great way to give the minor a head start in life, help educate them in financial ­literacy, and basic investment principles.”

Purchasing shares in a child trust account can be a rewarding way for parents and grandparents to help the next generation with a boost as they move into adulthood. Taking into account the tax-free threshold and shaping a portfolio accordingly can also result in a tax-effective investment vehicle.

But of course, if you are relying on growth and choose investments poorly, tax breaks are of no use if you are sitting on a large capital loss, so seeking expert advice from a stockbroker or financial adviser is recommended to balance the tax effectiveness angle with investment risk and future capital growth potential.