How to plan for school fees

By Nerida Cole, Dixon Advisory

Annual fees in some private secondary schools are around $20,000 per child and many parents put education costs in their top three financial concerns. Starting an investment programme early will help increase the power of compounding interest, but clever planning also means investors can come out well in front of the older-style education bond accounts, at a fraction of the cost, through the use of listed investment products.

Here are four tips to save for your children's education, using listed products:

1. Suitable types of listed investment products

Before investing, parents (or grandparents) need to first consider the number of years before the funds are required. Although any mix of listed investment products can be used to build a reserve for school expenses, growth-focused listed investments such as blue-chip shares, listed investment companies (LICs) and exchange traded funds (ETFs) may be suitable when the funds are not required for at least five years and preferably between seven and 10 years.

This longer investment term helps to average out the short-term volatility associated with growth investments, to achieve an overall positive return. For those with a shorter investment timeframe, the more income-focused preference shares, convertible preference shares and income securities may be suitable. However, each investment will have different terms and conditions, which should be considered against specific income requirements.

Blue-chip shares

These refer to the shares of companies that are well established and have had strong balance sheets and earnings over the long term. By investing in blue-chips, investors may be able to specifically target companies that pay fully franked dividends; those with dividend reinvestment plans; or those that pay little or no dividends but focus on growth, such as mining companies. This targeted approach may help parents to manage the level of income that will be taxable. As discussed later, when a minor's tax rates are considered this is an important issue.

However, because a range of different shares should be held to obtain diversification, and the investor may need to adjust positions and holdings as part of ongoing management of the portfolio, this approach can be time-consuming and incur higher-than-average brokerage costs. Using LICs and ETFs can provide diversified exposure to shares without the hassle and cost of managing a portfolio of individual blue-chips.

Listed investment companies (LICs)

LICs trade on the exchange like a share. But their main business is to manage an investment portfolio of other companies. Investing in an LIC can provide exposure to a diversified portfolio of investments - including Australian shares, international shares, private equity or specialist sectors such as wine and resources - at a very low cost. Typically, LICs have a management expense ratio (MER) of around 0.1-2.0 per cent and are easy to buy and sell.

Exchange traded funds (ETFs)

An ETF is a security that tracks an index, a commodity or a basket of assets, like an index fund, but also trades on an exchange, like a share. Usually very low cost, they provide an effective way to diversify a portfolio without incurring significant transaction costs. For example, StateStreet Asset Management runs the SPDRs (STW) S&P/ASX 200 index, made up of the entire S&P/ASX 200.

An annual management expense ratio of around 0.28 per cent is very competitive because investors obtain the diversification of the entire S&P/ASX 200 without having to continually reweight the portfolio according to changes in market capitalisation.

Preference shares, convertible preference shares, income securities

These instruments are often referred to as hybrid securities, because they are a mix of a debt (such as a bond or treasury note) and equity investment (such as ordinary shares). These types of investments are usually held for income needs when capital appreciation is not the main objective. Generally, they pay strong income with minimal capital movement. But if markets deteriorate, investors can still face significant falls in the market price.

2. Considerations when setting up ownership of investments

The ownership and control of investments is important in determining how the income and any eventual capital gains will be taxed.

If the investments are held in the name of the parent (or grandparent) the Australian Taxation Office (ATO) will consider the parent (or grandparent) the owners of the investments. All dividends and net capital gains will be taxed according to their marginal tax rate.

If the investments are held in the name of the parent (or grandparent) for the child, the ATO will look at who has control of the investments and who is using, or spending, the income from the investments, in determining the real owner.

If the parent or grandparent makes all the investment decisions and the investment income is reinvested or held for the child, the child is the owner of the investments and all dividend income and net capital gains are attributed to the child (minor's tax rates are discussed below).

However, in the case where the parent or grandparent not only makes all the investment decisions but also spends or uses the investment income as if it were their own, the ATO considers that the parent or grandparent is, in fact, the owner of the investments and all dividend income and net capital gains will be taxed at their marginal tax rate.

Where a formal trust, such as a discretionary trust, is established to hold the investments, trust distributions directed to minors will be taxed at minor rates.

3. Tax implications if children receive investment income

Eligible taxable income below $416 received by minors is tax-free. Amounts between $417 and $1307 are taxed at 66 per cent, and amounts above $1307 are taxed at 46.5 per cent. However, resident minors eligible for the $1350 low-income tax offset are able to receive up to $3000 in eligible taxable income tax-free.

Parents and grandparents should be aware that if the investment is held solely for the child, title can be transferred to the child upon turning 18 without creating an immediate capital gains tax (CGT) position because beneficial ownership does not change. The child inherits the cost base of the parent or grandparent and will pay CGT on subsequent disposal. If, however, the parent or grandparent has been declaring the investment income in their own personal tax return, the ATO may treat the transfer as a change in beneficial ownership that triggers CGT.

4. Other issues to be considered

As Centrelink usually attributes assets and income to the person in control of an investment, parents or grandparents need to consider the implications.

When investing for children, parents also need to be aware that dividends paid from ETFs may include some capital gains as well as dividends received from the underlying investments. If targeting a specific level of income for tax purposes, this may complicate the management of the investment.

The best results are usually achieved when an investment plan takes into consideration the goals, risks and objectives of the entire family. Building funds for education costs may be achievable through less direct routes such as paying down non-deductible debt earlier, or boosting superannuation.

The suitability of other strategies will depend on a range of factors, including the age of parents, salary level, equity in home and job security, making it important to obtain strategic advice from a qualified financial adviser.

About the author

Nerida Cole, Executive Director, is the head of Dixon Advisory's Financial Advisory Division. Dixon Advisory has helped more than 15,000 Australians build wealth, assisting them to develop sound financial strategies tailored to their individual situation.

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