It is common for parents or grandparents to want to set aside savings for their children or grandchildren - for a range of reasons including their education or to help with an eventual house purchase. However, investing on behalf of children can be complex due to limitations in being able to hold investments in the name of a minor and taxation penalties on the investment income of children. These penalty rates apply to discourage adults from hiding their own money in a child's account to avoid paying tax on earnings, and apply to eligible income derived from dividends, interest, royalties and property.

Tax rates for a minor 2010/2011 Financial Year
Eligible taxable income	Tax payable
$0 - $416	Nil
$417 - $1,307	66% of the excess above $416
$1,308 +	45% of total income that is not excepted income

THIS IS NOT TAX ADVICE. TAXATION ADVICE SHOULD BE SOUGHT.

Tax effective investment options

One way to avoid this complexity is through an investment held via an investment bond or education savings plan. Both types of investments have unique tax treatment that make it simple to invest for a child whilst retaining. Both investment vehicles offer access to a variety of investment options managed by investment professionals across various asset classes such as cash, fixed interest, property and shares, just like managed funds.

Investment bonds

Investment bonds are tax paid investments, with tax paid on the investment earnings at a fund manager level (at the corporate tax rate which is currently 30%) and earnings do not need to be reported on the investor's annual tax return. Once the investment has been held for 10 years the earnings are also not required to be declared in the investor's tax return and no additional tax would be payable. Where the 10 year rule has not been satisfied before a withdrawal is made, all earnings are taxed at your marginal tax rate and the tax already paid by the fund manager can be used to claim a tax offset. A reduced tax treatment applies where the withdrawal is made during the 9th and 10th years.

Under the 125% Rule, additional contributions of up to 125% of the previous year's contribution may be made without affecting the tax paid status of the bond. Additional contributions made under the 125% Rule will acquire tax paid status 10 years after the initial investment was made (rather than 10 years after the additional contribution).  It is important to note that if no contribution is made in a given year, no further contribution can be made without restarting the 10 year period, and if the 125% rule is breached then the 10 year period is restarted.

An investment bond can be held on behalf of a child through a 'Child Advancement Policy'. Under the Child Advancement Policy, the adult as the policy owner can nominate a future birth date that falls between the child's 10th and 25th birthdays known as the vesting age when the ownership of the transfer can be transferred to the child and no stamp duty is payable on the transfer. At the time of application the nominated child needs to be less than 16 years old, and if no vesting age is nominated then the transfer automatically occurs when the child turns 25. Prior to the child reaching vesting age, the policy owner has full control over the investment, and is able to transact and make changes as they wish.

Education savings plans / scholarship plans

Education savings plans are specialist investments for parents or grandparents who would like to set aside savings for the specific purpose of the child's education. Education savings plan are also tax paid investments meaning that tax has been paid by the fund manager at the corporate tax rate and while the investment remains within the savings plan, it is not necessary for the investor to report earnings on their own annual tax return. Education savings plans are generally operated as a 'scholarship plan' in accordance with the Income Tax Assessment Act 1997 which entitles the fund manager to obtain a special tax benefit of $30 for every $70 of earnings used to pay education expenses that is ultimately passed on to the student beneficiary.

Similar to an investment bond, the parent or grandparent is the plan owner of the investment for the nominated student who will receive the education benefits. Unlike an investment bond, an education savings plan is not subject to the 10 year and 125% rules. Instead there is a cap on the amount of contributions that can be made on behalf of the nominated student. The maximum contribution that can be made for each student is $365,000.

An education savings plan can be opened by anyone over the age of 16 and investments can be made in the name of individual, joint, trust and company investors.

Entry fee rebates

Like most managed funds, investment bonds and education savings plans charge entry fees of up to 4% each time an investment is made. Click here to browse investment bonds and education savings plans via 2020 DIRECTINVEST for full entry fee rebate.