As a child I remember my father saying that one pound put into a bank account for a newborn child and left to compound for 30 years would be worth some huge amount of money. I do not recall the number, but to my young ears it seemed some incredible sum of money - like a telephone number (although remember that telephone numbers were only four digits in those days).
Whatever the actual numbers, we all know that a relatively small amount of money invested for a newborn baby will be worth a tidy and useful sum in 20 to 30 years. There are many of us who want to help their child or grandchild - we want to make a gift of money and use the miracle of compound interest to support the new little miracle of life.
So, how do we go about this? After all, intent is one thing but the practicalities are quite another. While it may seem a simple thing to use the power of compound interest for the years a child is growing, when you really look at it, things are not that simple.
The first difficulty is the ownership of the fund that is established. If the fund is in the child's name, on turning 18, the money becomes that child's. That may be fine - you may be perfectly happy for the child to take the money and buy a motorbike and have a big party, but the intent of putting aside some money is more usually for the child's education or to help with the deposit on a house.
As an alternative, you may hold the money for the child, resolving to give this money at a certain age or circumstance (eg, first house or tertiary education). The difficulty with this is that in the absence of any legal document to the contrary, the funds that you hold for the child will be yours and deemed so in areas like tax, asset testing, Working For Families, insolvency etc.
To resolve this you could establish a trust - but if you have not already established a trust there will be considerable expense for establishment and ongoing management and interest from the child's fund could be taxed at 33c.
The second difficulty is the investment strategy. It is easy enough to set up a bank account in the child's name and to make contributions to it which will mean that the interest will be taxed at the child's own low rate. However, a simple bank account will give low returns. This is important: for an investment of 20 years or more, there should be a very high proportion of shares and property. To illustrate, a gift of $10,000 put into a simple bank account earning 3 per cent would be worth $18,000, but a growth portfolio earning 6 per cent would be worth $33,000.
The third difficulty is tax. This is linked to the ownership of funds: if the donor (parent, grandparent etc) owns the fund, the returns are taxed as their income; if the child owns the fund, they are likely to be taxed at a much lower rate.
So, given the desire to use the power of compound interest to give the child the best start, what should you do? Well, there are options, but none of them is perfect: first, you could simply open a bank account in the child's name (but, as shown, the lower returns will mean that compound interest is lower too).
Second, you could set up a KiwiSaver account for the child, a nice cheap solution with better returns and good tax treatment. (However, the child really needs the money at around age 20. Although the child may be able to withdraw from KiwiSaver for a first house, if some future government rescinds that ability, the child will have to wait 65 years to receive the money.)
Third, you could establish some kind of trust for the child (but the costs of this mean that you will have to gift a good deal of money to make it worthwhile - and there are also difficult tax considerations).
I do not have an easy answer to this. Your love for that new little speckle of life means that you want to help, but you have to recognise that, in a practical sense, using compound interest to give that help is not simple.
You need to weigh all the factors and then choose the best (although probably imperfect) means of help for your family.
Martin Hawes is an authorised financial adviser. A disclosure statement is available on request and free of charge, or can be found at martinhawes.com. This article is of a general nature and is not personalised financial advice.
- © Fairfax NZ News
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