21 February 2017

Andrew Proudfoot

Director - Risk & Succession

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Last week, we introduced the concept of an insurance bond for tax-effective saving outside superannuation. We also touched on a unique sub-class of insurance bonds, known as education bonds, which can be used to invest for your child/grandchild’s future in a tax-effective way and to make certain educational expenses tax deductible.

 

The Challenge

I am not sure about you and your family, but I know I was an expensive son growing up – school expenses, uniforms, the ill-fated tilt at the Clarinet, the more successful school sporting tours and the equipment bill that went with it, the move from Cairns to Brisbane at eighteen, residential college fees at the University of Queensland and – the icing on the cake – the course costs for a dual degree. You get it – the list goes on!

However, as the son of bankers and reflecting back as a parent now, prudent planning was the key to managing this period of our lives. In various ways, our childhood and education influences how we manage expenses and money. If there is a certainty in life beyond death and taxes, it is that raising children is a costly exercise. A recent television advertisement put it close to $950,000 out to age eighteen. In terms of educational costs alone across primary and secondary schooling, expenses are typically around $4,000 per year at a public institution and can be as high as $30,000 at certain private schools. University is similar. Clearly, these are expenses that (ideally) need to be well planned and saved for. The question is how?

Saving and investing in a child’s name is generally prohibitive for tax reasons. A tax rate is imposed at 66% on every dollar of income in excess of $416 per year. For this reason, many Australians simply do not invest directly in a child’s name and will instead open up savings accounts or share portfolios “as trustee for” their child. The drawback to this is the interest/dividend income earned typically needs to be declared in the adult taxpayer’s name (usually on a tax rate over 30%). When the time comes to liquidate the portfolio to cash to pay for expenses, capital gains tax considerations become relevant and costly. An education bond overcomes some of these structuring and tax challenges in a simple, effective manner which should be explored by every parent and grandparent.

 

Education Bonds

When it comes to purchasing an education bond for education savings and expenses, it is important to determine whether the product is deemed a ‘scholarship plan’ under Australian tax law. Where this is the case, and if purchased through a Life insurer, the Life office obtains a tax deduction for certain education expenses the child incurs, which is then effectively passed on to you when earnings are withdrawn to pay for those educational related costs. This can be worth up to $30 for every $70 of earnings used to pay for educational expenses.

Designed for lifelong learning through school as well as university, anyone can contribute to an education bond and the funds can be accessed for any purpose, not just education funding (the educational expense withdrawal aspect simply creates a tax-effective strategy to what would otherwise be non-deductible). To help explain this, we have put together a case study.

 

Case Study

After Peter and Mary Smith gave birth to their first child, John, they put aside $100,000 so John could attend the same independent high school his father and grandfather had attended. Alexander (John’s extremely proud grandfather) put aside $200,000 for the same purpose.

At a family BBQ celebrating John’s pending first week at Prep, Alexander lamented the additional tax impost they all incurred by simply holding this money in their names and paying tax on earnings. Mary, having read about education bonds, brought this up in conversation as a potential strategy that might work to pool these funds and expenses for John and any other children of the extended family.

Peter, Mary & Alexander sought advice and the following strategy was proposed

  • John is age 5 at commencement. Peter & Mary are happy for John to attend their local State school for his primary education before attending a private institution from grade 5. Factoring in indexation of costs, the Smiths allowed for $8,000 – $9000 per year in expenses to be withdrawn during primary school and $29,000 – $48,000 for high school. The total cost of primary and high school education funding needs for John would total $379,683.
  • In knowing this was going to be a funding strategy that needed to last and meet their needs over 12 schooling years, it was collectively determined by the Smiths that the low interest rate environment made this a challenge and instead of simply holding the funds in Term Deposits alone, they would target a net rate of return of Cash Plus 2% using prudent well researched investment managers.
  • The $300,000 initial capital is placed in a Trust controlled by the family which then purchases an education bond that invests the capital across several quality fund managers. After taxes, product and advisory costs, a net rate of return of 4.1% is assumed. The Bond generates and pays tax internally for the Smiths meaning Peter, Mary & Alexander (whom are all on a personal marginal tax rate of 47%) do not have to declare any interest/earnings in their personal returns nor the Trust. This saves them 17% tax on the earnings the investment generates compared to if the investment was in their own names or jointly held (as the Life Office pays tax at the corporate rate on their behalf with no top up tax payable).
  • Mary invoices all school fees, uniforms, books, music lessons, school sports equipment, school outings and travel expenses to the education bond. Mary also invoices the residential boarding costs to the education bond as John boards at a private institution for his final year of schooling.
  • After 12 years of schooling, the education bond delivers the following for the Smiths:
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  • Following his year 12 graduation, John intends to follow in his mother’s footsteps and pursue Medicine at the University of Queensland with an MD Observership at University College Dublin at the end of his first year. The Smiths can withdraw the $92,016 left in the education bond tax free to be distributed to any beneficiary of the Trust or they can choose to leave the funds in the Bond and invoice John’s Australian ‘HELP’ fees and foreign course elective costs to the Bond. If they chose the latter option – to leave the funds in the Bond and pay for five years of eligible expenses at $25,000 per year – the full 17 years’ worth of funding across primary, secondary and university education is broken down as follows:
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Educational expenses are traditionally not thought of as an expense that can be tax-effectively managed. However, as seen above, with a small amount on planning, they very much can be. If you have any questions about education bonds and how they can be integrated into you financial strategy, please don’t hesitate to get in touch on (07) 3391 5055 or via advice@mgdwealth.com.au. Over the coming months, we will explore other tax-effective strategies using insurance bonds, such as property funding via discretionary trusts, applications in overcoming Div7A challenges for SMEs, aged care funding strategies and elder law uses as well as using annuity-like income streams from insurance bonds.

Disclaimer: This article contains general information only and is not intended to constitute financial product advice. Any information provided or conclusions made, whether express or implied, do not take into account the investment objectives, financial situation and particular needs of an investor. It should not be relied upon as a substitute for professional advice.