How to invest for your child's future

By Mike Ross from Evergreen Advice and Gavin Cairns & Joshua Pietras of TDSL Lawyers.

Every parent wants what is best for their child and this usually includes a future that is financially secure. In an age of eye-watering house prices and accelerating inflation, there has never been a more important time to start planning for your children’s financial future.

How do you decide what to invest in?

With any investment strategy, it is important to define what you are trying to achieve i.e., your goal. Is it to help your child get onto the property ladder? Save for their education? Or simply to cover potential unexpected costs of parenting?

Defining the goal will help you understand how long you are going to invest for, and therefore what type of investments you should use. The longer the time frame, the more you can invest in growth investments such as shares, and the higher your return is likely to be, which equates to a greater level of financial support you can provide your children.

How much do you need to save?

The answer to this question is very specific to your goals but using the Sorted Calculator can give you a good idea of how much you need to set aside to achieve a specific amount. The FMA provides estimates of investment returns for different investment types which can be used in the Sorted Calculator.

A few general rules hold true and will help you on your investing journey:

1. The earlier you start to save, the more your investments can grow through the power of compounding: $50,000 invested for 10 years at an average return of 5% could grow to $81,000. However, invest that same $50,000 for 20 years and you could have $133,000.
2. Small, consistent actions can lead to big results. Many parents won’t have a large initial nest egg to begin investing. No worries. Investing a fixed amount on a regular (e.g. monthly) basis is a great way to save for a goal. If you invest $230 per month for 20 years in a portfolio that returns 5% per year, you will have $100,000 to help your children.
3. Remember that investment returns aren’t guaranteed and are variable. Even in more conservative portfolios, in any given year we don’t know how investment markets will perform so your investment value can, and will, go down at points. Don’t let this distract from your goal of financially supporting your children.

Should the investment be in your child’s name?

Beyond the decisions of how much to save, and how to invest, you should also consider whose name the investments should be made in. The main considerations include:

• How much control you want over the investments in the future.
• The tax the investment will incur.
• Will any other parties (e.g. creditors) be able to access the investments?

Below are three common ways of investing for your children’s future and some pros and cons of each option.

Save or invest money in your own name

The simplest way to put aside money for your children is to open up a separate savings or investment account in your own name. Or, even easier, just add to your current investment portfolio and plan to use some of these funds to help your children in the future.

The advantage of this option is that you will retain a significant degree of control and flexibility over the investment. Some parents find that their teenager or young adult may not be mature enough to use the funds wisely at 18 or 25, so prefer to have discretion on when the money is given. You will also still be able to draw on these funds to meet any unforeseen expenses if your own personal circumstances change.

However, there are also disadvantages with this approach. Any investment funds held in your own name will be treated as your personal assets. You will have to pay income tax on any earnings based on your own tax rate, which is based on your income level. Additionally, the investment funds could be lost if you are made bankrupt, face a relationship property claim following separation with your spouse or partner, or any other claims were successful against you in your personal capacity.

Pros: Ease; Control for the parent on when and how much to give it to their children
Cons: Likely not as tax-efficient; Could be taken in the event of a relationship break-up or other events

Setting up an investment account in your child’s name

There are many investment providers out there who now offer investment accounts for children. These have become a very popular option as more parents are wanting to teach their children about good saving and investment habits from a young age. However, each provider will have its own specific terms and conditions which you should consider carefully before proceeding.

Generally speaking, when you set up an investment account in the name of your child, you are creating a relationship known as a bare trust.

A bare trust is a legal concept where the duty of the trustee (you) is to hold funds and act in the interest of the trust’s beneficiaries (your child). The parent is merely the trustee and must administer the account for the child’s sole benefit.

All money received in the account is treated as a non-reversible gift to the beneficiary, meaning that the parent cannot access the investment funds for any reason personal to themselves.

The investment fund provider will typically stipulate when and how the investment funds will transfer to the beneficiary, generally between the age 18 and 25. Once the funds are transferred to the child, the parent ceases to have any control over them. This means that the child now owns the funds outright and can do with them as they please.

An advantage of setting up an investment account in your child’s own name is that it is generally more tax efficient. This tax difference can add up over time, potentially adding more than 20% to the value of the investment over a 20-year period. It is also less likely to be attacked by creditors in the event that you go bankrupt.

You should be aware that if the child’s investment earnings exceed $500 during any given tax year, these will likely be treated as part of your income when assessing eligibility for certain state benefits, such as Working for Families.

Pros: Tax-efficient; Generally safe from parties claiming on parent’s assets
Cons: Minimal control on when your child receives the fund and what they do with it

A variant on this option is to open a KiwiSaver account in your child’s name. This option provides the same benefits as a standard children’s account but has different implications in relation to when the child can access the funds. The two main ways to access KiwiSaver assets are when they look to purchase a first home, and in retirement.

While this appears an attractive option for helping your child purchase their first home, we would highlight that your child may not want to buy property or may prefer to use these funds in another way such as their education or starting a business. Also, there is no guarantee that this first home withdrawal will be available in the future. Most other countries do not allow the withdrawal of retirement savings to help purchase a first home and there is a small risk in the future that New Zealand could withdraw this option.

Setting up a discretionary family trust to protect your child’s assets

A discretionary family trust can be an important tool for succession planning and asset protection. In general, here’s how a trust works.

• The person setting up the trust is called the settlor. The settlor transfers legal ownership of their assets to the trustees. The trustees do not own the trust assets outright, but simply manage them for the benefit of the beneficiaries. The Trust Deed will either identify the beneficiaries by name, or more commonly, it will define the beneficiaries by reference to a class of persons, such as the children or grandchildren of the settlor.
• Trustees have a number of mandatory duties, including a duty to know the terms of the trust; to act in accordance with the terms of the trust; to act honestly and in good faith, to act for the benefit of the beneficiaries only, and to exercise their powers for proper purposes.
• Importantly, trustees also have a duty to invest the trust funds prudently, unless the Trust Deed states otherwise. In practice, this means that trustees must have the requisite knowledge to manage the investments themselves or should seek advice from qualified professionals

An advantage of a discretionary family trust is that it provides flexibility. Discretionary beneficiaries have no particular right to the trust funds. They merely have a right to be considered for a distribution. The trustees’ discretion allows them to exercise a significant degree of control over how and when the trust funds are distributed to beneficiaries.

Another key aspect is that trust funds are better protected against business risk, creditors risk and spousal claims and do not form part of the settlor’s or trustee’s personal estate. When your children are older and start their own relationships, the trust can be a useful mechanism to provide benefit to them while still protecting the assets against claims from their own partner or spouse.

The disadvantage of this strategy is that setting up and running a trust comes with a cost and time commitment. There are costs associated with setting up and running a trust, from the initial upfront costs of preparing a trust deed and transferring the assets to the trustees, to the ongoing costs of annual administration. Income generated from trust assets will either be treated as trust income taxed at 33%, or beneficiary income at the beneficiaries’ marginal tax rate (though the IRD has some specific tax rules in relation to income payments to children under 16).

Pros: Control on when the assets are distributed; Higher level of protection against claims from others including children’s partners in the future
Cons: Added cost and time commitment to setup and run

What does this mean for you?

Setting aside some of your savings and investing for your children is a great way to help them financially. As with all investing there are some common rules to follow to help achieve these goals: start as soon as you can, consistently contribute, and stick to your investment plan during the inevitable ups and downs of the market.

With children’s accounts there are also some specific decisions to make in terms of whose name the investment should be made in. This decision involves considering the trade-offs between the tax treatment, security, future control and administrative time and cost of the investment. There is no one answer to this question, and you should review your own specific situation, and seek advice if required.