An exchange-traded fund offers tax benefits as well as flexibility
Excellent question, Nitin. Investment bonds always strike me as a pretty ancient investment vehicle and are not my preferred option. The big issue is that they are not “totally tax free”. The correct term is that they are a “tax paid investment”. What this means is that the returns they earn each year are taxed at the current company rate of tax of 30%.
Clearly, a salesperson or supporter of these bonds could fairly argue that a bond paying 30% each year has a lower tax rate than you would pay if you invested in your own name.
Investing in the name of your son is not going to be a great idea as minors (those under 18) pay very high rates on “unearned income”. I suspect that this is why you may be looking at an insurance bond. In your situation, investing in an insurance bond to provide an after-tax payout for your son's education in a decade or so is not the world's worst idea but I don't think it is the best either.
I do appreciate that as a doctor you are likely to be in the maximum tax bracket. We should also consider that if you are married it may be that your wife is a lower tax payer and the investment could be held in her name as trustee for your son. But let's go with the higher taxed scenario and look at investing the $500 a month in your name as trustee for your son. I agree that an exchange-traded fund is a good way to go, as also would be a low-cost indexed fund offered by a firm such as Vanguard. You will pay brokerage fees each time you buy and sell ETF units so may be worth directing your monthly savings into an online account and buying once a year.
There is little argument that with a view of at least 10 years you should opt for a growthstyle investment. This type of investment would be mainly international and local shares. These assets tend to generate lower income, and in the case of international shares this would be close to zero. Local shares tend to pay franked dividends with a 30% tax credit attached to the income. So my view is that even if the shares are held in your name the tax liability would be low.
There would be no tax on capital gains as I can't see any reason to sell the investment until it passed to your son. And this is an important point. Providing you invest in your name “as trustee” for your son, he is the beneficial owner. When he turns 18 you can transfer the investment to him without any capital gains tax liability as he has always been the beneficial owner.
So in my view this is the way to go. You would pay some tax on income received but this is not the main game. That is capital growth, which would pass to your son untaxed until he chooses to sell. I expect his income, as a university student, to be nil or very low, so selling this investment, in particular if he did so over a number of years, would be most unlikely to see any tax liability.
All in all, in my opinion, this is a better and more flexible option.
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