LAST UP-DATED: 29 August 2007
Here are some answers to questions I have received about the plan from readers of the books.
Please feel free to email me at ashley@investing101.com.au with any comments and questions you may have. I am not set up to be able to respond to specific questions about readers’ individual circumstances, but I can add an entry to the FAQ section.
NOTE: the responses to questions below do not constitute financial advice. Each reader must consider whether and how the information applies to their own individual circumstances.
Please refer to the
Financial Services Guide
before acting on information contained in this communication
The questions are organized into the following groups:
1. General
2. Structure
5. Tax
6. Investments
Important information and Notices
1. General
1.1 What if we didn’t start the $1 per day plan in "How to give your kids $1m" when the kids were born?
Start as soon as you can – the earlier the better. It’s never too late to start investing. You can make up for lost time by starting the plan with a lump sum (even a few hundred dollars goes a long way) and/or making the contributions more than $1 per day – eg $40 or per month to start with. That way you can get back on track for the $1million. Several examples are provided in the book and this web site. See Accelerate the Plan...
1.2 Can we start the plan before the kids are born?
Yes. Start the plan as soon as possible. The earlier you start, the bigger and faster the fund will grow. If you are opening accounts before the child is born, you won’t be able to put the child’s name on the accounts just yet. If you are absolutely certain that you have decided on the future child’s name, you can probably put the name on the account (after the parents’ name), because the bank is only interested in the identification of the parent, not the child, when the account is opened. It is probably better to add the child’s name to the account after the child is born, when you have finally settled a name. When the child’s name is added to the accounts, the parents will be holding the funds on trust for the child from that point onward. It will be treated as a loan (or gift if you want to make it a gift instead of a loan) to the child, and the fund (and any income from it) belongs to the child.
1.3 What if we don’t have kids – will the plan still work for adults?
Yes. You can start the plan in your own name. Set up the accounts and salary deduction as set out in the book. Name the accounts something like “John & Jenny Smith <Investment Fund>”. Just remember that it is not to be used as an “emergency” cash fund for you. This fund is never to be spent. Ever. It is to be kept in tact in order to generate investment earnings to live off in the future.
1.4 Can I get to the $1million in less time?
Yes. There are many ways you can get to $1million much sooner than the simple $1 per day plan. Several examples are given in the book, and also on this web site. There are four things you can do to accelerate the plan:
1) start off with a lump sum if you can – even a few hundred dollars makes a huge difference.
2) start with more than $1 per day contributions – for example make them $40 or $50 per month if you can.
3) increase the contributions each year – eg. increase by 10% per year. So if you are starting with $40 per month in the first year, make it $44 per month in the second year, etc. This way you’ll be staying well ahead of inflation.
4) Make additional contributions when you can – eg. make part of your Christmas or birthday present a contribution to their fund.
There are several examples my "$1Million for Life" book.
One thing you shouldn’t do to try to accelerate the plan is try to go into speculative investments or schemes in search of higher returns. Stay well away from “tips” and “sure winners” offered by friends or strangers. Stick to the basic, low cost, tax effective investments outlined in the book and you will get there if you stick to the plan.
1.5 What about inflation?
This is covered in detail in "How to give your kids $1m" - chapter 6.7. Because of the effects of inflation, the value of $1million in 30, 40 or 50 years time will be less than the value of $1million in your hands today. Therefore it is best if you steadily increase the contributions each year in order to keep well ahead of inflation. This should be possible in most families because their salaries or business income would also be increasing due to inflation each year. Examples of how this can be done are given in the book.
1.6 My employer won’t let me set up a Salary Deduction.
If you work for a small business (or if you own the small business) you may not be able to set up and automatic salary deduction. If this is the case, the next best thing is to set up a regular direct debit going from your main transaction account into the new cash account for your investments. It is a good idea to set it up so that the money comes out a couple of days after your salary or other income goes into the transaction account weekly, fortnightly or monthly. That way you won’t get a chance to spend it first. For example if you get paid each Friday, then set up a weekly direct debit to take $7 out each Tuesday. Or if you are paid at the end of each month, then set up a monthly direct debit to take out $31 on the 3rd day of each calendar month.
1.7 I’m self-employed – I can’t set up a Salary Deduction
See above.
1.8 Shouldn’t we pay off the mortgage before investing spare money?
I cover this issue in both books. It is always a good idea to pay off all debts on which the interest is not tax-deductible, as soon as you can. (Generally, interest on loans taken out to buy investments, like rental properties or businesses, will be tax deductible, but interest on all other loans is not – eg. home loans, car loans, boat loans, personal loans, credit cards, etc.). Every family should make it their top financial priority to pay off all these non-tax-deductible loans as quickly as possible – starting with the loan with the highest interest rate first.
On the other hand, it is also a good idea to start a long term investment plan as soon as possible. We’re only talking about a tiny $1 per day for this plan, so it is unlikely to break the bank in most families. The best solution would be to do both – start an investment plan with $1 per day (or say $31 per month), and re-arrange the family’s affairs so that an extra say $50 or $100 per month goes toward paying off non-deductible debts.
1.9 How can the kids plan “not cost you a cent” if parents are making contributions?
Parent’s make the regular contributions up to the time when the kids can take over the contributions, which is when they are around 15 years old or so. So, if the contributions are $1 per day, the total the parents contribute over 15 years is around $5,000. The parent’s contributions are a loan, not a gift. The loan is to be repaid out of the fund when the kids are say 30 or 40 years old, when the fund has several hundred thousand dollars in it. Because the parent’s loan is repaid, they get their $5,000 back and that’s how the plan doesn’t actually cost them a cent.
It is much better to make the parents’ contribution a loan rather than as a gift, because it teaches the kids that there is no such thing as a free ride in life. It is also an essential part of the plan that the kids learn to take over the responsibility for making regular contributions from the time they start to earn money of their own. They learn to put a small amount of whatever money they earn into long term investments for their future. This is a powerful lesson for them to learn as early as possible.
If the parents’ initial contributions were more than $1 per day when the kids were young, then the total amount contributed by the parents would be greater than $5,000, but the fund will have grown much faster to the $1million, so the parents can get their loan repaid earlier – perhaps at year 25 or 30.
1.20 What if my kids don’t earn money from jobs?
Ideally, the kids should learn from the earliest possible age that they should put aside a small amount for the long term from any amount they receive – whether it is from pocket money, chores, outside employment or any other source, like gifts from grandparents.
Many parents want their kids to concentrate on schoolwork while they are at school, and don’t allow their kids to get part time or casual work until they leave school. This is fine – and the plan will still work. But it will probably mean that the kids cannot take over complete responsibility for the $1 per day contributions until they start to earn regular income – which might be when they are a bit older than some other kids who started casual work while at school. Either way it shouldn’t matter too much in the long term.
2.1 Should each child have their own separate accounts?
Yes. Even though the parents make the contributions to the fund while the kids are young, the money in the fund is the child’s money, not the parents’, so each child needs their own accounts. The book covers the topic of how to set up the accounts on trust for the child. When the kids are 10 years old or so and you start to get them involved in the plan, it is vital that they see their own money growing in their own accounts. This means that each child will have their own separate cash account, on-line broker account, and salary deduction (or direct debit) form the parents’ salary or bank account.
2.2 We have set up a single account for all three kids. Can the plan still work?
Having one account for all three is fine - I presume the kids are very young and not old enough to help out in the plan yet or appreciate that it’s their money to look after (eg under about 10 years old). Having one set of accounts instead of three saves on admin and paperwork. But once the kids start getting involved they get really excited about seeing things in their own individual names - they really start to take ownership and interest in it. So, individual accounts give each child a sense of ownership in their own fund.
If you are starting out with a single account covering the three kids, then you would hand each child a slice of the pie at some point in the future - eg when they are old enough to get involved and take some ownership.
I know of one family with SIX kids and they are setting up separate accounts for each child. They range in age from 15 down to 5, and most of them are old enough to start getting involved in looking after and contributing to their funds, so it is better to have their own separate accounts.
2.3 Opening accounts without the child’s parent’s consent
"My son in law would not let me open an account and get a tax file number etc for his 2 children, so I have decided to do it all in my own name and then when they girls get old enough to understand, I will hand it over to them. Will this work?"
and
"Can I set up accounts and add "in trust for" my nephews and nieces without their parents knowing about it? Would this be legal without their parent consents? I am going to start without them knowing and give it to them when they've grown up. "
and
"What if I’m separated and my ex-partner has custody of the kids?"
The kids don’t need to sign anything when the initial accounts are set up, because the forms are signed by the trustee (you). But it is always best to get the consent of the child’s parents or guardians because the parents (or guardians) will be the ones who will need to sign things like the child’s application for a Tax File Number, Application for Refund of Franking Credits each year, and then the tax returns in later years. These must be done by the child’s parent or guardian, not the trustee, because it is the child’s money and the child’s income.
So, if you can't get the consent and co-operation from the child's parents or guardians, it might be better to keep the accounts in your name initially. Eg. If your name is John Smith, you might just call the accounts "John Smith - investment account number 1", "John Smith - investment account number 2", etc. The advantages are that you control it yourself, and the child's parents can't sue you to get their hands on the money. The disadvantage is that the money belongs to you and not the child, so you have to include any investment income from the fund in your own tax return.
Later on, when child's parents or guardians do agree to the plan you can hand the fund over to the child and/or the child's parents. You simply give it to the child as a gift (or loan). From then on the fund is the child's and they include any income as their income, not yours.
But the products used in the plan are still very tax effective even when they are held in adults' hands, so you shouldn't lose very much in tax, especially if you open the accounts in the name of a person in a low tax bracket. For example you might be the child’s grandparents, and you can’t get the child’s parents to agree on the plan. In that case you might put the accounts in the name of the grandparent in the lowest tax bracket (the one who has lower taxable income). After a few years, it will be a great surprise for the grandkids - and their parents!
2.4 In whose name should the accounts be opened?
"I set up the account in my wife’s name as she is at home with our 3 children and earning $0 income, which means she is entitled to tax rebates just as the kids are. We chose to set this up in my wife’s name rather than the kids due to receiving higher interest in the bank account. At what stage should be move this money out of my wife’s account and into the children’s? When she starts earning over $25k per annum? She will be at home for another 3 years minimum due to being pregnant with our 4th child, but I thought I would ask this question while your book is still fresh in my memory."
I presume you set up the accounts in your wife’s name only – without hold on trust for the kids – ie only the wife’s name appears on the accounts. With the fund in your wife's name, she gets the same "low income tax offset" as the kids, and she is also entitled to get franking credits refunded. The added benefit is that she is not subject to the "penalty tax" threshold which applies to children's investment income. But in practice this doesn't affect the kids on this plan for many, many years - especially if each child has their own separate fund. Each child can earn up to $1,325 in investment income per year before paying any tax. This would take around 20 years in the basic $1 per day plan. Once they are over 18 years old they are taxed like normal adults – with no “penalty” tax rates.
I notice you say you put the account in your wife's name instead of the kids, in order to get higher interest. If the account is set up as "wife's name in trust for kids names" or "wife's name <kids' names account>" the banks will regard it as being in the wife's name and they will pay normal "adult" interest rates.
2.5 Trusts
"Is it worthwhile setting up a formal trust (ie not just a trust account) for each child and then adding the investments to the trust. From what I have read (in "How to Legally Reduce Your Tax" by Tony Melvin & Ed Chan) it seems that any investments should be protected for later life, probably via a trust. Before we start would be a good time I think."
There can be several benefits from setting up formal trusts - asset protection, flexibility of spreading income around to low-tax family members, etc. But there are also some disadvantages of trusts – for example:
1) cost - need to do accounts and lodge tax returns each year (around $500 pa for a simple trust) + also the cost of initial establishment (about $1,000 for a simple one). In many cases, accountants also advise clients to set up a company to act as the trustee of the family trust. That adds another $1,200 to set up and another $500 or so each year for accounts and returns.
2) in most states property held by trusts don't get several benefits - like tax free thresholds for land tax, or stamp duty discounts - this can make property investment significantly more expensive through trusts in many cases.
3) when borrowing for investments held in trusts, banks often charge higher fees – for example mortgage document preparation and establishment fees.
4) some financial institutions don't set up certain accounts for trusts established under formal trust deeds.
It's a bit like deciding on whether to set up a Self Managed Super Fund - it depends on your whole family's circumstances, and if the amount of funds is large enough to justify the expense. There are also several different types of trusts - so it pays to get advice from your accountant for the best solution for your family. As a general rule of thumb, it starts to become cost effective for amounts above $200,000 or more in the fund.
Personally, we use a combination of discretionary family trusts, unit trusts, hybrid trusts, companies, SMSF, and a charity foundation. They need to be carefully designed to suit what you are trying to achieve. But for the investment funds for the kids, we just use the simple accounts in our name "in trust for" the kids names.
The other thing to note is that many of the people advising on setting up trust structures are in the business of making money via fees from setting up trusts. The best thing to do is talk to your regular accountant - he/she will understand your full circumstances and will be in the best position to advise you.
2.6 Starting the plan with several older kids
"We have children aged 14, 12, and 9. Obviously, the 9 year-old will benefit from the system at an earlier age than the older children. I agree with your recommendation that the money should be a loan rather than a gift. In addition to the monthly contributions, we have the capability of starting each account with a lump sum. What do you believe is the fairest way of catching up? These are the options that I can see:
1. Place the same lump sum in every child's account and contribute to the plan for a set number of years (e.g. 25 years). In this case we will be lending the same amount to each child, but the youngest child will be younger when the portfolio reaches each milestone.
2. Place proportionately more money in the older children's accounts to help make up for lost time and stop making contributions when each child reaches a certain age (say 35). In this case the children should be about the same age when they reach each milestone, but we will have lent more to the older children. The oldest child will thus have to repay more than the youngest child.
3. Proceed mostly as 2 above, but split the loan amount evenly between the three children so that they each owe us the same amount at age 35. The 9 year-old would be subsidising the older children.
There are probably other ways of approaching the problem.
I am hoping to wimp out and base my decision on your recommendation (an expert). This will make it easier to deal with the inevitable "it's not fair" from one or more of the children: I can blame you."
Setting up the accounts for kids of different ages. If you wanted to set up the 3 accounts for the 3 kids so that they would all be on equal footing there are a few options;
a) Set up the 3 accounts now and put enough cash into them so that it puts them in the position they would have been in if you had started at birth for each child. (assuming $31 per month contributions and assuming an average 12% return per year). To do this you would need a total of $26,500 to put in now.
Age Contribs Value
9 $3,400 $5,500
12 $4,100 $9,000
14 $5,200 $12,000
The amounts in the “value” column are the amounts you need to set up the accounts now. The amounts in the “contribs” column are the hypothetical contributions you would have made had you started at their birth, so these are the “loan” amounts that they owe the parents. The rest of the money has hypothetically come from investment earnings and compounding had they started at birth.
This way the kids are all in the same boat relative to their age. They have different amounts now, but you also contributed different hypothetical amounts (loans from you).
This total amount of $26,500 that you use to set up the accounts really needs to be surplus to your family’s cash needs. You can’t get it back to pay school fees, or to buy a new car in a couple of years, etc. Make sure you don’t need the money in the foreseeable future, and that you have plenty of spare cash left over for emergencies.
b) If you can’t spare this $26,500 in spare cash now, you can start the plan this year for all 3 kids and put them in the position they would have been in if they started when they were say 4 years old each. You would set up the accounts with:
Age contribs value
9 year old less 4 = 5 years in the plan $1,900 $2,400
12 year old less 4 = 8 yrs in the plan $3,000 $4,600
14 year old less 4 = 10 yrs in the plan $3,700 $6,500
This would require a total of $13,500 to start the plan now. The kids are still in the same boat for their different ages – different balances but different loan amounts.
c) If you can’t spare this much cash now, you can start the plan this year for all 3 kids and put them in the position they would have been if they started when they were 9 years old.
Age contribs value
9-9=0 years in the plan $0 $0
12-9=3 years in the plan $1,100 $1,250
14-9=5 years in the plan $1,900 $2,400
This would require a total of $3,650 now.
In each of these options, they should reach the target at around the same age (assuming they all invested in a similar way and made similar contributions) and the loan amount to you would be the same. It might be different, of course, if each child took over the contributions at a different age – eg if one left school to work full-time while another stayed on to study, of contributed more, etc, etc. But those are their decisions to make.
2.7 One set of accounts for each child or all in together?
"I have read your
book, and have now saved enough money for my 4 children to put $1000 for each of
them into shares. I would like to know if I should buy 4 X $1000 lots so each of
them have their own, or if I should just buy 1 X $4000? They are 1, 2, 3 and 5
years old so they have a long way to go before they will take control of the
money. I am not sure on what would be the cheapest, make the highest returns?
Perhaps diversify the 4 X $1000 into 4 different sectors and the 4 children can
have 1/4 of all profits?"
Even though the parents make the contributions to the fund while the kids are young, the money in the fund is the child's money, not the parents', so each child needs their own accounts. The book covers the topic of how to set up the accounts on trust for the child. When the kids are 10 years old or so and you start to get them involved in the plan, it is vital that they see their own money growing in their own accounts. This means that each child will have their own separate cash account, on-line broker account, and salary deduction (or direct debit) form the parents' salary or bank account.
Having one set of accounts instead of three saves on admin and paperwork. But once the kids start getting involved they get really excited about seeing things in their own individual names - they really start to take ownership and interest in it. So, individual accounts give each child a sense of ownership in their own fund.
If you are starting out with a single account covering the four kids, then you would hand each child a slice of the pie at some point in the future - eg when they are old enough to get involved and take some ownership.
I know of one family with SIX kids and they are setting up separate accounts for each child. They range in age from 15 down to 5, and most of them are old enough to start getting involved in looking after and contributing to their funds, so it is better to have their own separate accounts.
Having one fund of $4,000 is cheaper to run than 4 funds of $1,000 - mainly in the brokerage costs. But this disadvantage diminishes over time as the size of the funds grow.
If you put the cash account and broker account in your name (instead of you in trust for the 4 individual kids or 4 kids together), then the money is still yours and you pay tax on investment earnings at your marginal rate. You don't get to take advantage of the kids' tax free thresholds.
If the cash account + broker account are in your name as trustee for all 4 kids together, you will still need to lodge 4 individual tax returns or applications for refund of franking credits) for the kids. Also you will need to split the money up and open new accounts for each once they reach the age to take over their accounts. Splitting up accounts can be tricky later on - you may have to sell investments and pay tax on any capital gains.
One way might be to set up one cash account (your name in trust for all 4 kids), and link it to 4 separate broker accounts - one for each child. The cash account won't generally have much in it (so not much to squabble about) - most is in the broker accounts invested in securities. This would make paperwork easier - only one direct debit in each month and only one set of bank statements. But once the kids get old enough to start contributing and saving themselves, it would be easier with a cash account each. You can always take this step in say 10 years time, meanwhile each has their own broker account all along.
(The cash account and broker account names don't actually need to line up exactly - in fact most broker accounts will link to any valid cash account in any name - as long as it has cash in it to settle trades. I only recommend matching up names for convenience - especially if you have lots of different accounts for different people, companies, super funds, etc).
If you do set
up 4 separate broker accounts for the kids you need to think about what
investments to buy in each. Probably saves arguments later on if you do the same
investments in each - eg. simple ETFs or a couple of LICs - the same in each so
the performance is the same. When the kids are old enough they can start
to pick their own shares (but always leave the ETFs and LICs in place as the
core of the funds).
3.1 "Are cash accounts safe? What if the bank “goes broke”? What happens to the cash in the cash account?"
In the plan we only use cash accounts run by licensed Australian banks. The Australian banking system is one of the safest in the world. The federal government and Reserve Bank do not actually guarantee deposits with licensed banks but they will do everything in their power to prevent depositors losing their money. There are numerous regulations and protection measures which all licensed banks need to comply with to hold their banking licence. So it is extremely unlikely that depositors will lose their money deposited with a licensed bank in Australia.
Building societies and credit unions which are not licensed banks do not have the same level of protection as the banks. This is not to say that building societies and credit unions are not safe. Many have been operating successfully for over 100 years. Depositors in building societies and credit unions are also very unlikely to lose money, but the safest place for cash to be held is in a licensed bank. It's not worth taking any risks with our kids' futures, so we stick to the safest place, which is in a licensed bank.
As far as I know, no depositor in a licensed bank in Australia has ever lost their money. When a bank does get into trouble, the government and the Reserve Bank step in to make sure depositors’ money is protected. You may recall the financial disasters caused when several State government-owned banks got into trouble in the late 1980s and early 1990s. Every State government except Queensland had a government-owned bank, and they all got into trouble and made huge losses, were closed down and restructured and/or taken over by the big commercial banks. But no depositor lost their money. The banks were simply taken over by other banks and depositors' money was protected. The last time a non-government owned bank got into trouble was in 1979 when the government arranged for ANZ to take over the Bank of Adelaide (nothing to do with the present Adelaide Bank!). All depositors were protected.
3.2 What about the small banks – are they as safe as the big banks?
Although the federal government doesn't technically "guarantee" bank deposits in any Australian bank (not even the Commonwealth Bank), they will step in if there is any trouble and make sure that no retail depositor loses money. Some licensed banks are huge (like the “big-4” – Commonwealth, NAB, ANZ and Westpac), and others are very small (eg. Arab Bank, Bank of Queensland, Elders Rural Bank), but all licensed banks are treated the same and are subject to the same regulation and supervision by the government. Deposits at licensed banks are the safest and most secure way of holding cash in Australia.
3.3 Making deposits to cash accounts
"I have a question about making deposits via the mail into an online cash account. In the book you mentioned that your family has been doing this for years and haven't lost a deposit in the mail yet. It sounds like this actually means physically sending notes and coins in an envelope along with a deposit slip. (It sounds a little risky to me!) Or did you change it into a money order or cheque first - I can't see how that would be cost effective either. If you could make that clear I would greatly appreciate it."
On the point of depositing money to the kids' accounts - We have used cash management accounts at Macquarie Bank, Adelaide Bank, Commonwealth Bank and BankWest over the years. But I've never actually done transactions at any of their branches. Most transactions are electronic, but there are 3 main reasons for needing to make manual deposits every few months:
1) dividend cheques from shares and distribution cheques trusts (like Listed Property Trusts, ETFs. etc) - almost all of them have automatic direct crediting of dividends & distributions direct into the cash account. But a couple of them can't do direct crediting. The reason is that each company or fund sets the rules that dictate what the share registry can and cannot set up. Sometimes the company rules state that the account can't be credited automatically if the shareholder name doesn't EXACTLY match the name of the bank account. ING Office Fund (a Listed Property Trust) is an example. The names don't match up because the bank account is in the name of "my name as trustee for the child name", but the broker account (and therefore CHESS account and Share registry database) is in the name of "my name <child name account>". Most company rules allow this minor variation in names, but a couple don't. So, almost all of the dividends are direct credited straight to the cash account, but every few months we get a chq in the mail. No big deal - we just send off the cheques in the mail with a deposit slip to the bank.
If you choose a bank without a local branch, when you're setting up the cash account, make sure you ask the bank staff (on the phone) the quickest, safest way for deposits to be credited to the account. Ask for the exact address to send deposits for that particular account. It's normally not the address of the branch, it's usually a "money market" department in the Bank HQ. That way the deposits go straight to the right place every time.
2) Take-overs and re-constructions - Occasionally the company or listed fund we have invested in gets taken over or merges or is reconstructed in some way. Often this will result in getting a lump sum of money. Even though you have set up the dividends and distributions to go directly into the cash account, sometimes these large one-off lump sums are paid out by sending a cheque in the mail instead. So we send it off in the mail with a deposit slip to the cash account.
3) The third kind of manual deposit is the kids putting in the money from their "investment" money boxes into their cash account every few months. No, you should never send coins or notes in the mail. If the kids have $97 in coins or notes to put in, I would just write a cheque for $97 using the cheque book on our family cheque account, and put it in the mail with a deposit slip for $97. Then we put the cash from the money box into OUR chq account - over the counter at the local branch - or use it as "petty cash" at home.
Our main family cheque accounts are with one of the big-4 banks and we get half a dozen "free" cheques per month. But we rarely write cheques these days - mostly we use "pay anyone" or BPay functions via the on-line banking service. So, over the past couple of years we no longer write cheques for the kids deposits, we can use the "pay anyone" function from our account to their accounts using our bank's on-line banking system, using the BSB and account number for the kids' accounts. It's free and instant, and you get a receipt number straight away.
But when the kids are very young, they like to see their money being handed over to a bank teller. So we can take them to OUR (the parents’) main bank branch and hand it over to the teller and watch them count it. What the kids don't know is that the money is actually going back into the parents' account (meanwhile we have already zapped the money across to the kids’ account using the "pay anyone" function from the on-line banking system, or we have sent off the chq for the same amount to their own cash account).
This is a great motivator for the kids - they actually see their money going into a bank, and it's a great habit to get them into from an early age.
3.4 Cash Account – in kids’ names
"I have been unable to set up an ERBonline Savings Account in trust and I have been advised by the Bank’s helpline that online accounts can only be set up as individual or joint. Are you able to shed any light on this issue?"
Yes, many banks try to limit their high-rate accounts to individuals (and joint accounts), but don’t allow companies, super funds and trusts. They have two good reasons for this:
§ to prevent accounts with lots of transactions (like companies, trading trusts and solicitors or accountants’ trust funds), and
§ to prevent accounts being opened for huge amounts. These accounts are really meant for small-medium accounts with minimal transactions - perfect for us.
In your case you are not a big company or trust, etc, and you won't be using it as a transaction account. If it's just you in trust for your child then it can be set up in the name of: “John Smith - Junior account" in the same way that many people set up other individual accounts like: "John Smith - household account" or "John Smith - holiday fund account", etc. I have talked to the staff at several of the banks and they will allow individuals can set up accounts like this. Just avoid using the term "trust" because they are afraid it might be a business account, with lots of transactions, etc - which it isn't.
3.5 The bank says that child must be 12 years old to open an account
"I recently contacted Elders Rural Bank to set up an account and they told me I couldn't open an account unless my son was 12 years old. When reading the terms and conditions myself it said that I could open it with him as a beneficiary, but wasn't able to use internet or phone banking with the account. I'm not sure if you have heard of this being a problem in the past."
Banks generally don't like the traditional type of kids accounts because they tend to use branches a lot, have lots of tiny deposits, and very low balances. So banks are very reluctant to open the traditional accounts for kids - and that's why most of the specific kids’ accounts pay virtually no interest.
Here you are opening an account in YOUR name(s), not the child - in the same way as you might open accounts called for example "J & A Smith - household account" or "J & A Smith – holiday account". The new account could be called "J & A Smith - Junior Smith account". Don't tell the bank that it's a child's account – you want them to treat it as a regular adult account paying regular adult interest rates. But by opening it as "J & A Smith - Junior Smith account" it will achieve the desired result, and it will be treated like a normal adult account. But as far as you, the child and the tax man are concerned, the fund belongs to the child, because you are setting it up with the clear, express intention of being for the child's benefit.
3.6 Do I need internet and phone banking access?
Banks often have a policy that kids’ accounts don’t get access to the money via internet and phone banking. But in our case the accounts are in the adult’s name, but held on behalf of the child. As far as the bank is concerned the account is held by an adult, so the normal terms and conditions for adults apply. By opening the account as an adult account (on behalf of the child) you can use whatever internet/phone, etc functions are attached to the account.
Personally I've never used the internet & phone banking functions of the cash accounts linked to our on-line broker accounts. Occasionally we need to do a "pay anyone" transfer INTO the account (eg to bank the kids' investing money box every few months), but that is done by using the internet banking function of our main bank account, not the cash account.
The Cash account linked to the broker account is there ONLY to take regular salary deductions, direct credits of dividends, the occasional pay anyone credit from our main bank a/c, and to settle trades for buying investments. Setting up the internet/phone banking/ATM functions, etc is unnecessary for the plan because all the transactions are done using the online broker account when we buy and sell investments or receive dividends, etc. I rely on the paper statements (and my own book-keeping spreadsheet) to keep track of the balance and check interest paid and transactions.
3.7 Cash Accounts – “CMT” versus “CMA” ?
"Some cash accounts are called Cash Management “Accounts” (CMA) and others are called “Cash Management Trusts” (CMT). Eg. Adelaide Bank offers both a CMA and a CMT, but the CMT pays higher interest rates. Isn't the CMT product a Managed Fund?"
Yes, technically CMTs are “managed funds”, but they’re not the same as the "active" managed share funds which try to beat a benchmark like the All Ordinaries Index. What we’re looking for is a cash trust which invests in bank bills and other very liquid instruments, and is run by a licensed bank.
Cash Management Accounts (CMAs) sit on the bank’s balance sheet and is guaranteed by the bank. But CMTs don’t sit on the bank’s balance sheet and are not technically guaranteed by the bank, although they’re managed by the bank. CMTs generally pay higher interest rates than CMAs for this reason.
That's why it's important to read the PDS (Product Disclosure Statement) for the product you are considering, to check that you're happy with what the money is invested in. For example here are several funds out there (not run by licensed banks) which claim to be cash funds, but are really mortgage funds, which are very different. For example, many of the investors who were caught up in the Westpoint disaster (4,000 investors lost around $400 million) thought they were investing in a safe cash fund, but it was actually a high risk mortgage fund.
In practice a licensed bank would never let one of its CMTs get into trouble. That would cast a shadow over the bank's management of it's whole business, which it would avoid at all costs. In our family we use the Adelaide Bank CMTs and also the Macquarie Bank CMTs (both covered in the book) - which are off-balance-sheet CMTs, rather than on-balance-sheet CMAs. The best plan is to read the PDS and to make sure you understand what the account does.
3.8 "How much should you keep in the Cash Account at any given time? Is $500 OK or can you have less?"
Under the plan, it assumes that the money going into the fund is for the very long term - ie assumes that it is completely outside your family's cash needs over the next few years or longer. For example, you aren't planning to use it for a deposit on a house in a few years, or to buy a car, etc. Also, it assumes that you have other emergency funds - eg in cease you are retrenched, get sick, etc. So, the money in the fund is purely for building long term wealth, and you won't actually need it for say 10 to 20 years or more.
Having established that, then most of the fund should be invested in growth assets for pretty much all of the time. The only reason there is cash in there is that with small contributions it takes 6 months or so to build up enough to invest in listed investments. The smallest parcel size for listed investments on the ASX is $500 per investment, so you need to collect at least $500 in cash before you can invest it.
In practice, if you are starting out with $1 or only a few hundred dollars initially, then you would just keep collecting cash until you get to above $500 in the account. Then if you use the $500 to buy the first investment, then the cash would drop to only a few dollars. That's why we use cash accounts with a $1 minimum balance. Each time we collect another $500 or $1,000 in the cash account, we buy more assets.
Once the fund builds to a few thousand dollars you will find that the fund will start to generate more growth all by itself than the amount of contributions you are putting in. (Eg. your contributions might be $400 in one year, but dividends + capital growth might total $500 or so - so the fund is accelerating all by itself!). The dividends and distributions from the investments should also be invested back into growth assets.
Most dividends and distributions are paid half-yearly. So, over the years, you will end up buying things about twice each year.
Also, if the total fund size is say $5,000, then probably there would only be around $500 to $1,000 in cash - the rest is in growth assets. Even in funds I manage with hundreds of thousands of dollars in them, only a thousand or so sits in the cash accounts. The rest is put to work in growth investments.
3.9 "I currently bank with the Commonwealth Bank and have a CommSec account. Would you know if they offer the kind of accounts that can meet your criteria ? I searched their web site, but they don't seem keen to clearly disclose account fees"
If you have more than $5,000 in cash then the CDIA is ok - it's the account which is intended to go with the Comsec broker account. But pays nil interest below $5k. Otherwise you can use any of the other high rate accounts which will link (CommBank has none which link to broker account). Eg I have several Adelaide Bank a/cs linked to Comsec. But any of the others mentioned in the book would work as well if you are happier with them.
The only downside with having another bank's account as the cash account is that you don't see the cash balance on the Comsec Portfolio screen. You can only see the balance one one screen if it is a CDIA account linked. Even if you don't have $5k in cash the fact that the CDIA pays no interest is not such a big deal because 95% plus of your fund is in shares, not sitting in cash. The main reason for getting interest on spare cash is to provide motivation for the kids to see interest on even only a few dollars in the account. If you don't mind this, the CDIA/Comsec combo is hard to beat for a simple solution - easy to set up and easy to manage. I use this combo for some of my funds.
3.10 "I have just seen advertised on the internet that Rabobank offering an at call online savings account with no fees and paying 6.7% interest. They are just setting up in Australia I take it. The account works just the same as the ING Savings Maximiser but pays much better interest. This looks like the best option going around for a cash account."
Yes the Rabobank account is not bad - similar to most other hi-rate internet accounts. You still need a transaction account for it to operate - doesn't link directly to an on-line broker trading account (similar to ING and almost all other internet accounts unfortunately. Rabo have been in Australia for several decades - mainly in the rural sector - and also big in mortgage origination as well.
4.1 Why does the online share trading account need to be in the same name as the bank cash account?
To settle trades, most brokers don't mind if the name of the linked cash account is completely different to the name of the broker account. As long as the cash is in the cash account to settle the trades, they don’t mind. But it is a different matter when it comes to paying dividends and distributions. Various companies and share registries have various rules about account names. What we want to achieve is the dividends and distributions from the companies going directly into the linked cash accounts. Unless the names match up this is often a hassle. Eg. sometimes if a middle initial is missing from one of the accounts, they will not match the accounts - meaning that they will send dividends, etc via chq (instead of direct credit), and you must then bank it into the cash account. Not fatal, but inconvenient.
Also, if the money goes back into the parents general bank account, it is easy to lose track of the money (eg. how do work out how much interest it earns back in the parent's account? - you'll need to work it out because the interest belongs to the child) - we're trying to separate the child’s investment fund so we can measure it and watch it grow for the child.
4.2 What happens if the online broker firm goes broke?
With the investment plan, the cash is held in the cash account that is run by a bank. The brokerage account itself doesn't hold any assets or cash. It is just the account used to buy and sell investments. The actual investments are held in the investor's name, held by the share registries of the individual companies and investments you invest in. If the broker collapses, the investments are still in the investor’s name. Stockbrokers are also subject to lots of rules and regulations to ensure investors are protected.
4.3 What happens if the online broker firm is taken over by another broker?
Every few years, one of the online brokers is bought by another online broker. This has happened to me 3 times over the past 20 years. When it happens the customers shouldn’t be affected. Their accounts are transferred to the new broker service. The investments are still held in the customers’ names. The investments don’t need to be sold and re-bought, so there is no capital gains tax payable.
Usually, the cash accounts also change banks, but the broker organizes this to happen automatically, so customers don’t need to go through the hassle of re-opening cash accounts all over again. The only hassle for customers is that they need to re-set up their salary deductions so that they go into the new cash account.
5. Tax
NB. Neither the book nor this web-site provides comprehensive tax advice. There may be specific circumstances in your family which mean that other tax rules apply. It is important to get tax advice from your accountant or tax agent which covers your own individual circumstances.
5.1 What about Tax on investment income?
Taxation is covered in the book, including the special rules relating to taxes on kids. The book contains several examples and exercises illustrating the way taxes apply to the investments used in the plan. The plan utilizes ways of investing in shares and property using relatively tax-effective types of investments. Because of the way the tax laws operate, in many cases the kids will actually get tax refunds from their investment earnings instead of paying tax. Examples are provided in the book.
5.2 What about the cost of tax returns for the kids?
As outlined in chapter 3.5 of the book, because the investment income from the kids’ funds will below the $416 threshold for around the first 10 years of the $1 per day plan, they will not be required to lodge tax returns during these years if the income is under the threshold. However, they will want to be lodging an Application for Refund of Franking Credits each year in order to get back franking credits from company dividends in those yearly years. This is a relatively simple form that can be downloaded from the Tax Office web site and completed using information provided on the Dividend Statements received from the investments.
5.3 When applying for cash account and broker account do I use the Tax File Number of the child or the parent?
When opening cash accounts, the bank and broker wants to know the TFN of the legal owner (ie the parents), not the beneficial owner (kids). On the other hand, the kids will need their own TFN in order to lodge applications for refund of franking credits, and, later on, tax returns. This is because it is the childs' income, not the parents'. Once the child’s TFN has been obtained, it is usually a good idea to record this on the cash account and broker account. This can be done by ringing the bank and broker call centres.
5.4 Tax File Numbers used to open accounts – Child’s TFN or Parent’s TFN?
"If I open an account John Smith - Junior Smith account, can I legitimately put the kids tax file number on it? Isn't the bank actually asking me for mine? Can they tell? Won't alarm bells go off if I use the kid's TFN? And if I use my TFN, but then of course not claim the interest on my tax return because it's actually the kid's, won't I end up getting audited?"
If the child has a TFN then you can record that on the account. In practice, young kids generally won’t have received their TFN yet so you can use the parent’s TFN on the new accounts. Financial institutions don't know who's TFN is on the account, as long as it's a valid number. What they ask for is the TFN of the legal owner (the parent), not the beneficial owner (the child). There is an encoded algorithm that the tax office provides which the banks use to determine whether the TFN supplied by the customer is valid. Once a valid number is entered they destroy the form (or they're supposed to anyway). As far as the bank is concerned the parent is the legal owner of the account, and the legal owner must supply a valid TFN (or they will take out withholding tax).
That's why it's perfectly legitimate for parents to open accounts for kids even before the kids get a TFN. The kids don't need a TFN to open the account, the parent does, because the trustee is the legal owner of the account. The kids use their TFNs to lodge their application for refund of franking credits (and later to lodge tax returns).
It's the same with super funds and any other type of trust account - the account is in the name of the legal owner(s) - the trustee(s), but the fund is beneficially owned by the beneficiary. The trustees are the legal owners and it is the trustees' TFN which is recorded on file.
When the tax office does the data matching between their tax records and the bank computers they are interested in beneficial ownership, not legal ownership of accounts. Even though the trustees' names are the legal owners, the fund (and any interest and other income) belongs to the beneficiary. Again, no different to super funds and other types of trusts.
5.5 "If the parent’s name is on the accounts and the parents Tax File Number is used, won’t the tax office treat any investment income as the parent’s income, not the child’s?"
The Tax Office website outlines the following key question when determining whether the income from the child’s account belongs to the child or the parent:
"Did you receive, or were you credited with, interest from any source within Australia? For example:
a.. If you opened or operated an account for a child and the funds in that account belonged to you, or you spent or used the funds in the account as if they belonged to you, you must include any interest from the account"
The trustees (parents) need to demonstrate that the fund is genuinely held on behalf of the beneficiary (child) and that the parents didn’t spend the money or use the money as if it belonged to them.
In the case of a super fund it's easy because there is a formal trust deed. In the case of this plan for the kids there is no formal trust deed, so we establish intent by our actions over many years - eg:
- recording the child’s Tax File Number on the account as soon as it is available
- putting money in initially and leaving it in,
- making regular contributions,
- the name of the account (which shows the child's name as the beneficiary),
- the name of the broker account (similar),
- we can write a note and keep it on file stating that you are doing it for the child,
- involving the kids in the plan,
- setting up the kids' money boxes, etc, etc.
- clearly separating the fund from the parents finances
- re-investing the income back into the fund (which is in the name of the child)
- never taking it out and spending it
- never treating the fund or the income as the parents own funds
- never spending or otherwise using the investment earnings like it belonged to the parents
- following the steps in the book - which specifically states that it is for the kids benefit
By doing all of these things consistently over many years we provide evidence that the parent is genuinely holding the funds on behalf of the child - so it is the child's money and the child’s income.
On the on the other hand, if the parents were to put a large chunk of their own savings or their income into the account, then withdrew it again and lived off it, or lived off the income, then a court would say that it looked like the parents' own money, and therefore the income really belonged to the parents.
In our plan we're genuinely setting up the fund for the benefit of the kids, and we're doing it with very small amounts of money, completely separate from the parents' finances, so it really is a genuine fund for the benefit of the kids.
Your accountant or tax agent will advise you on what extra steps you might want to take given your unique family circumstances.
5.6 When the child turns 18 is all the "investment income" then taxed at the same rate as "earned income" i.e. First $6000 tax free etc
The special "penalty" rates on "un-earned" income (ie investment income) only applies to kids who are under 18 years old as at 30th June in particular tax year. So, starting from the financial year in which they turn 18, they are then subject to the same rules as adults, with the $6000 tax-free threshold etc.
5.7 "You state in your book that the kids should generally not pay any tax until the fund reaches around $25000 which would be when they are around 20 years of age under the $1 per day plan. By that age you would assume the kids would be earning an income (if even only part-time work) and their investment income would be added to their earned income and taxed at their applicable tax rate. However if I want to accelerate the plan by putting in more money the fund may reach $25 000 well before the kids are earning (even part time). Am I right in saying they would then have to pay tax at the top marginal rate (45%) from the time investment income exceeds $1445 (page 62) until they turn 18 (when the first $6000 would be tax free)."
If you accelerated the plan (thereby increasing investment income) and if the kids also had other non-investment income, then they would start to be taxed like normal adults. Even at the top marginal tax rates (like us), we still pay only around 15% tax on investment income because of dividend franking and tax-deferred and tax-free components of trust distributions.
You will soon discover that actually working for a living is the least tax effective way of making money! All other ways of making money - capital gains, super pensions, running a business, investment properties, shares, etc have all sorts of tax breaks available (discounts, depreciation, deductions, franking credits, etc), but working for a salary is the least tax effective way of all. Nobody except people on a salary actually pay anything like the marginal tax rates. Crazy but true.
5.8 "What if the kids have some income from employment and some investment income? How are they taxed? The employment income is subject to the normal tax rates, but the investment income is subject to the “penalty” tax rates."
The first thing to establish is that the money in the accounts really belongs to the kids and not the parents. Eg. by putting the accounts in the kids’ names, keeping the records separate from the parents records, following the plan, involving the kids in making contributions and managing the investments, the kids contributing their own money to the plan, etc, etc. That way you can demonstrate that the funds and income genuinely belongs to the kids and not the adults.
On the question of how to apportion the income from investments and from the child’s “earned” income from employment, I don’t think there are any precedents in court cases. Your accountant or tax agent will guide you depending on your own particular circumstances. What the tax office mainly looks for is the fact that you genuinely try to apportion the income fairly, and that you keep records.
Yes investment income earned from money collected from legitimate employment (ie. outside the house, not just pocket money or chores, etc) will generally be treated as normal income in the same way as adults. Whereas investment income from money not earned (ie the investment plan which comes from contributions from parents, pocket money, presents from relatives, etc) will be subject to the “penalty” tax rates.
But the threshold for “normal” income is $6,000 (including employment income + any investment income earned from funds generated from employment income). This is quite a lot for kids under 18 years old. Generally it will only be a problem if the kids are working full time or getting a lot of acting or modeling work, etc.
And the threshold for “investment” income is $1,325 (after taking into account the low income tax offset). So, if the average income yield from investments is 5%, then kids need to have more than $26,500 each in investments before the investment income starts to exceed the investment income threshold.
Even when these thresholds are exceeded, the taxes should be quite minor. For example, even if you accelerate the plan dramatically so that a child has investments of even say $50,000, the average tax rate on investment income would be less than 10%, once you take into account the impact of franking credits from shares, tax deferred income from property trusts, and the low income offset.
See the tax office web site: http://www.ato.gov.au/print.asp?doc=/content/20046.htm
Also make sure to talk to your tax accountant or tax agent.
5.9 "When my son turns 18 everything will be able to be in his name alone. The cash account can be closed and reopened in his name but what about the broking account and all funds/shares that are in my name but held for him. Will it be a big deal to change over names for these?"
On the question of transferring to junior's name when they turn 18 (or when you feel they are ready), all the assets (cash account, broker account, investments, etc) are beneficially held by junior from day one, so there is no transfer of beneficial ownership. You won't need to close accounts or sell investments, simply change the name from trusteee holding on behalf of the beneficiary, to the beneficiary holding outright. Trustee needs to write to the bank, broker (who will notify the share registries) declaring that the trust is at an end, so name can be changed. There has been no change of beneficial ownership so no capital gains tax, or stamp duty, etc.
Also make sure to talk to your tax accountant or tax agent, as there may be specific circumstances or other factors which may apply.
6.1 Why doesn’t the plan include managed funds?
In both books I outline several reasons why there are better alternatives than managed funds:
§ High Fees – up-front fees, annual fees and often exit fees as well.
§ Performance over long terms – which always suffer due to the impact of their high fees.
§ Tax – active managed funds trade shares more frequently than index funds or your own funds, so more capital gains tax is payable each year.
The books set out a number of ways that ordinary investors can get exposure to a broad range of shares without using managed funds.
6.2 DRPS – Dividend Re-investment Plans – are they a good idea?
DRPs - yes they are a great idea - I talk about them on pages 186 and 206 of the book. Many companies and investments offer Dividend Reinvestment Plans to their shareholders and unit-holders. Under DRP plans, shareholders and unit-holders can use their dividends and distributions to re-invest in more shares or units in the company or trust – instead of receiving them in cash. Often the new shares or units are at a discount to the current price – and there is no brokerage. When you receive the paperwork a few days after buying your investments you will be given the choice of signing up for the DRP.
In many long term funds where the investor doesn't need the cash they are highly recommended. There is one downside however - and that is the admin and paperwork attached to DRPs. For example if you take just one stock and set up the DRPs for each dividend, I've found that after say 10 years of DRPs I end up with up to 20 tiny chunks of shares - each with it's own separate cost base. So whenever I get a capital return or deferred income return from the investment I need to go back and adjust the cost base of 20 tiny shareholdings, not just the main holding. It's even worse with listed property trusts, because many have quarterly distributions and they almost always have capital returns and/or deferred tax distributions as part of their half yearly or quarterly distributions. And then there are take-overs, reconstructions, buy-backs, etc.
Also, over the years the various little DRP holdings are subject to the different Capital Gains Tax rules, depending on when they were issued. I don't like admin work, so I like to keep it simple. I know every little bit adds up - but so does all the admin work with DRPs! In practice I often take up DRPs on defensive stocks and bank stocks, and don't worry about it for cyclicals and growth stocks, because the dividends are lower.
On the other hand with the kids funds and some long term funds I manage, where they are really set and forget holdings of say a couple of ETFs and a couple of LICs, then they generally have DRPs working - especially if the discount is good - ie more than a couple of percent. Over recent years many companies have stopped giving discounts on DRPs, and I think in most cases the free brokerage benefit is not worth the extra admin work.
6.3 LICs versus ETFs
"Listed Investment Companies seem to serve the same purpose as Exchange Traded Funds in a portfolio, why do you have to use both when in fact AFI (Australian Foundation Investments) and ARG (Argo) both have fees less then 0.2% and they give you exposure to all the sectors of the market? "
Exchange Traded Funds (ETFs) like the StreetTracks funds are effectively listed Index funds - all they aim to do is mirror the overall market index. They don't analyze stocks and make judgments about what is a good stock or bad stock. They just follow the index weightings religiously. So, for example when the old News Corp (NCP) was dropped from the index, the ETFs dumped News shares. Now that the "new" News (under the new code NWS) is coming back into the index they will buy it again. Silly, but that's what happened!
Listed Investment Companies (LICs) are very different. There are two main groups of LICs - the old ones and the new ones. The new ones (the couple of dozen listed over the past couple of years or so) are very "active" - ie trade a lot, and have high fees and profit share structures, and often are not very tax effective because they tend to trade a lot and therefore have to pay capital gains tax. I have looked a few of them in depth in the past year or so, but they don't make sense to me. They are effectively listed "active" funds, and relatively expensive, with no track record. I don't touch them personally.
The old ones are the ones that have been around for several decades - like Aust Foundation and Argo which you mentioned, plus the others listed in the book. They have much lower fees as you point out, but they aim to beat the index rather than just match it.
Many of them have exposure across the main sectors, but they take particular views on particular sectors and particular stocks. For example, take Argo. For several years they have been very "heavy" on Macquarie Bank - that is their single biggest holding by far. This has been great over the past 10 years, while MBL has been a superb performer relative to the overall market. But they know that the outlook for MBL may not be so rosy in the future - with the rising interest rates, slowing global economy and more subdued outlook for the equities markets.
But Argo has been reluctant to sell any MBL stock because of the capital gains tax they will incur, so they are still holding. When the MBL share price reaches around $75 or more they may start selling some because it will be just too expensive to hold onto so much stock. In the meantime they have been writing MBL call options over his holding in order to generate some extra income from the stock. This is something which an index ETF would never do. It generates taxable income, not franked dividends - so the make-up of Argo's earnings is quite different to the ETFs. So that is a good example of how even the big old diversified LICs are very different from ETFs.
Also, some LICs believe in the "China growth" story and some don't - and that is reflected in their holdings - some are overweight resource stocks and some are very light on resources. ETFs don't care - they just buy resource stocks as they increase their weighting in the index.
Individual investors can make up their own minds on whether they think the China growth story is sustainable, and then choose their LICs accordingly. If they haven't got the time or inclination to worry about China, then why not just buy ETFs instead of choosing particular LICs.
In practice I know of several investors who rely on LICs pretty much entirely for their portfolios. But I also know people who use nothing but STW (the streetTracks 200 share fund) and SLF (the StreetTracks property fund). Both groups of investors have been happy in most years, and happy over the long term. Both are very "set and forget" type investments.
LICs pay mostly fully franked dividends and tend to vary a bit in performance relative to the index each year, and many also tend to have slightly higher income, but often less tax effective. The distributions from ETFs is very different - some is franked dividends, some is unfranked dividends, some is taxable income, some is deferred taxable income, some is capital gains, some is discounted capital gains, and some is tax free.
Personally, I have used both together to give smoother returns each year, and to get the best of both worlds. As I say in the book, they are very different animals, but both can be very cost-effective and tax-effective in building long term wealth. Readers can decide for themselves whether they want to use ETFs or LICs or both.
6.4 "Where do you get your ongoing "current" data for the All Ords Acummulation index & the Listed Property Trust Accumulation index? "
I get all current data from the Australian Financial Review. The month-end data for the Price indices (All Ords index, property trust index, etc) are in the paper the next day after the end of the month. The month-end data for the Accumulation indicies (All Ordinaries accumulation, Property Trust accumulation) is always a day later (lots of number crunching takes the extra day I guess!). Although the Financial Review changes the layout of the paper every couple of years (to keep readers guessing) these days the tables are just before the full share listings, in a section called Market Wrap, or Market Performance, depending on the day of the week.
6.5 "Where do you get all of the historical data for (i) All ordinaries accumulation index and (ii) Property trust accumulation index. I can’t find these anywhere on a "free" website."
Most of my old data comes from old ASX records. A lot of the really old stuff I got from old published records the ASX used to keep in its old ASX libraries in Melbourne and Sydney. But now that the ASX is a profit-driven listed company itself, it no longer has the libraries or keeps historical records on paper.
Now the ASX has outsourced the index keeping to S&P (Standard & Poors, which is a US research house), so the ASX has scaled back it’s resource and staffing so it’s hard to get data.
S&P sells historical data to fund mangers and stockbrokers for a fee. Plus also the major equities research houses would have the data - eg Morningstar, Aegis, etc. But they probably would not give it or sell it to investors.
If you track down historical index data you always need to be careful about exactly what data it is. Eg in the case of monthly index data, sometimes it is month-end, sometimes month start and sometimes month average. Sometimes the month average is simply the average of the month start and month end, and sometimes it is the average of the daily closes during the month.
Same for yearly data - could be year start, year average or year close, or the year average might be the average of daily closes during the year, or it could be the average of the 12 monthly figures, etc. And the year might refer to calendar year, or it might be financial year.
In the case of yearly index figures I always try to use the closing figure on the last day of the calendar year. And for monthly data I always use the daily close on the last day of the calendar month.
I suppose it doesn't really matter what definition you use as long as you're consistent, and everything follows the same rules, so you’re comparing “apples with apples”.
6.6 "I can find the StreetTracks [now called SPDR] funds on the ASX website using the stock codes, but I am having trouble finding them listed in the stock market pages of our local paper. Are they listed under a different name?"
In week-day editions, the Financial Review's share listing is a full alphabetical listing of all listed companies. The Sydney Morning Herald, the Melbourne Age and Australian also have full listings. The SPDR funds are in there alphabetically under S. In other newspapers in each city, they only list the top 100 or so stocks, not the full listing, so you won’t find them there. In the weekend edition of the Financial Review, the listed companies are sorted into categories. The SPDR funds are in the "Unclassified" section at the end of the listings.
6.7 "Once you have reached the million dollars (or more hopefully) and you want to live off the income, do you need to switch the investments to something that provides more income than capital growth (which would generate a lot of capital gains I would assume) or do you just leave everything as is and live off dividends paid into the cash account. (would need to cancel any dividend reinvestment plans). If roughly 5% of the 12% return was income then this would provide for an annual income of $50 000 from $1 000 000. The fund would still generate 7% capital growth which would allow the annual income to increase with inflation. If this is the case what happens in years when there is a negative return. Would you have to sell some of the assets to provide the yearly income and thus eat into the original capital. There would also be a tax component in all of this so the actual net income would not be $50 000?? "
If you have $1m invested according to the plan (ie shares, listed property and a bit of cash) then you can expect this to produce around 5% income and grow around 7% each year averaged over the long term. In fact that's what our investments do - and have done for many years. Even though we are in the top marginal tax rate, the actual tax rate paid on the investment income is only around 10% to 15% or less each year, because of various tax breaks - like franking credits from dividends and varying levels of deferred tax and tax free components of distributions from property trusts.
You're quite right in saying that every now and then the markets have a negative return - in fact one in 3 or 4 years will be negative years in terms of total return. But in those negative years it is the capital value which drops - ie your $1m might drop 10% to $900k. But you will still receive income. Companies are extremely reluctant to reduce dividends or cut them altogether.
In practice, most companies increase dividends each year in the good years (generally increasing by at least 5-10% each year) and in a bad year (even when they lose money) they will generally leave dividends and distributions at the same level. Occasional a company will reduce dividends and vary rarely one will cut a dividend altogether if they suffer really serious problems.
Let's say your $1m fund had 3 good years and then a bad year. So, the income might be $50,000 in year 1, $55,000 in year 2, $60,000 in year 3, then in the bad year (year 4), income might remain flat on $60,000 but more likely still increase but perhaps to only to $62,000 in year 4. The point is that the capital value might go up and down by 10 or 20% year but the income is much more stable. It would be vary rare indeed that dividends and trust distributions across a broad spread of investments actually fall in one year. I can’t recall it ever happening in my portfolios, even through the 1987 “crash”, the “recession we had to have” in 1991-2, the 1994 “correction” or in the dot.com bust in 2001-2. Capital values went up and down, but income still increased.
By the way, if the capital value falls and income remains the same, then the yield must rise (maths). That's exactly what happens. Sometimes the yield gets up to 7% or even 8% because share values have dropped, but the income remains constant or keeps rising. The opposite happens in boom years - when capital values rise by a greater rate than dividends, the yield sometimes drops to only 2% or 3%. But over the long term yields from shares and property trusts have tended to average around 4% to 6% pa.
6.8 "You describe in your book, not in detail, the selection of Direct Shares and the selling of non performing Direct Shares, Page 190 "Avoid the 'dud' companies". I would like to know what criteria and the criteria values you use to make decisions (eg. P/E ratio etc) to buy and sell?"
Picking companies - ah yes the million dollar question! There are two broad principles I follow. The first is to recognize that you have a natural advantage in industries you know well. For most people it is the industry they work in or are close to via hobbies or family connections, etc. If they turn their mind to it, most people would know much more relevant information than the best fund managers, analysts or stockbrokers. I find that most people have the right sort of knowledge but are not used to applying the knowledge and turning it into company analysis which they can then use to choose the best companies and avoid the duds.
The second principal is where you don't have particular knowledge of the company or industry. You would be aware of the two main camps – “technical analysis” (looking primarily at the historical price and volume data on a company's trading) and “fundamental analysis” (looking at balance sheets, profit & loss, management skill, industry dynamics, competitive positioning, etc). And the fundamental analysts come in 2 main flavours - "growth" (mainly looking at earnings per share growth, margins, sales, market shares, etc) and "value" (mainly looking at asset values, debt levels, return on equity, Price Earnings ratios, etc).
The bookshops and libraries have hundreds of books on share investing covering the whole spectrum of theories, and it's up to each person to discover for themselves what works for them. Some people just want to be told what to buy or sell and when. Others will want to understand what they're buying and why. Different people have different risk tolerance (eg how they react when the share price halves - some buy more because it's cheap, some sell the lot because it's a dog, others just wait, others don't worry about the share price, etc).
A good approach might be to put most of the money you have set aside for shares into things like ETFs and/or LICs, and then experiment with a few different methods and see which works for you. Take your time and do some research and see what works.
I could write a whole book on it but there are hundreds out there already covering every possible angle, so I'm not sure what one more book would add.
6.9 "How do I get exposure to overseas markets – especially in the emerging economies – Brazil, Russia, India and China (the so-called “BRIC” countries)?"
On the question of international markets, including the “BRIC” countries - my approach is to aim for listed index funds first, before trying the active funds (for the reasons of lower cost, greater diversification, more tax effective, not trying to beat the index, etc, etc). For most of my international exposures I use US-listed Exchange Traded Funds. The biggest player by far is Barclays Bank with more than 100 US-listed "i-Shares" ETFs. You can access the US markets with most Australian online brokers (like ComSec, etc).
Each of the hundred or so “iShares” funds tracks a particular index. visit - http://www.ishares.com/ for lots of info on them. They are all listed on either AMEX or NYSE (most Australian online brokers can access both of these US exchanges).
In addition to over 50 US index funds (tracking various sectors and Sub-sectors of the US market), “iShares” also has 23 different country index funds + another 8 regional funds.
Here are some useful iShares ETFs to look at:
- EEM - Emerging Markets (BRIC + Sth america, SE Asia, Sth Africa)
- FXI - Xinhua/China 25
- EWZ - Brazil
Also might look at:
- ILF - Latin America 40
Use the 3-digit stock code to look them up on a free US market site like www.bigcharts.com
State Street Global Advisors (the firm that runs the StreetTracks funds in Australia) also has a number of international funds but they are not as strong as iShares in the area of international markets, especially emerging markets, where iShares are much more extensive. (See http://www.ssgafunds.com/)
With these US-listed international funds you are dealing in US dollars, so you have the USD currency exposure as well as the country risk exposure. All distributions (most are quarterly) are paid in US dollars as well. Personally I am happy to have this US dollar exposure because of the long term declining trend in the Australian Dollar.
Of course, there are many active listed and unlisted funds which try to beat the various country indexes and sector indexes, but I stick to the low cost ETFs (or direct shares once you get to know individual stocks).
I cover this issue in more detail in "$1Million for LifE".
6.10 "What if all the companies in the funds went broke? Ie the 50 companies in the SFY fund, or the 200 companies in the STW fund or the 30 property trusts in the SLF fund.
Individual companies do go broker every now and then. When they do they usually suffer a share price fall for several months or years before they just collapse. As the share price fell, their index weighting would fall and they would drop out of the top 50 or top 200 company index. As it dropped out of the index, the fund manager would sell it and buy the company that took its place in the Index.
For example, let's say that BHP is the largest company in the top 50 and top 200 indexes with a share price of say $40. If things went wrong at BHP and its share price dropped to say $5 or even $0, it would drop out of the to 50 index so the SFY fund would sell its shares when it dropped out, and buy shares in the company that took its place in the index (so there would still be 50 companies in the index).
The chances of ALL 50
of the largest 50 companies collapsing at once is extremely remote. Don't forget
that the market has survived world wars, great depressions, military attacks,
droughts, and lots of other things over the past century or so. Of course this
is no guarantee that an even bigger disaster is not possible in the future - eg
a meteor like the one which wiped out most animal life on earth 65 million years
ago. Another meteor like that, or an all-out nuclear war, would cause the
whole world economy to melt down - and most people would lose everything. But
these things are 1 in a million chances.
6.11 "Can the ETF fund manager (State Street Global Advisors) go broke? What happens if it does?"
They are a huge firm with several billion dollars under control - mostly in the US where they are based. Their primary business is running their ETFs and they have been in business for a couple of hundred years. Check out their website - www.ssga.com. If the management company got into trouble, the assets in their funds are owned beneficially by the unit holders (which is you and I) and not them, so they couldn't just take the assets. To get money out of the funds they would have to increase their fees they charge the funds. They probably could not do this because the unit holders would vote against it, and also because investors would sell their units and invest in other competing ETF managers instead (eg Barclays Bank in the US, which is the other major global player in the ETF market). So competition would keep the fees very low.
The assets of the exchange traded funds are shares in the top 50 or top 200 listed companies on the stock exchange (eg. BHP, NAB, Telstra, etc). The actual holdings are listed by each fund daily. Go to your online broker (or www.asx.com.au) and type in SFY or STW. Click on the "News" or "Announcements" icon and you will see their daily report to the market on what shares they actually own each day.
On the other hand, most ACTIVE fund managers have only been around for a few years or so. The active fund managers regularly go out of business and investors often lose some or all of their money. The PASSIVE fund managers (like ETFs) aren't trying to do anything fancy with complex products and derivatives, etc. So they are much more likely to be around for many many years.
There are no guarantees, of course, so make sure you read the Product Disclosure Statements before investing (can download from their website).
6.12 Index Funds versus ETFs and LICs
"You say that that Index Funds are unsuitable in the first few years of the $1 per day plan as most have an initial investment amount of $5000. You say that we can achieve similar results by using exchange traded funds and listed investment companies. If we did happen to have $5000 would an index fund like Vanguards Lifestrategy - High Growth be a simpler option and achieve the same results as using the ETF's and LIC's?
The advantage of the vanguard funds is that they use index funds as the underlying investments. They are much better than the active funds because the fees are much lower and you know you are going to get the returns achieved by each underlying index - less the fees. Each "life strategy" fund invests the money into a range of underlying index funds which track a particular index. In the case of the high-growth fund it invests in these:
Australian fixed interest 4%
International fixed interest (hedged) 6%
Australian shares 48%
International shares 29%
Property securities 10%
Emerging markets 3%
For a high growth strategy over long periods - eg 10+ years this is a fairly standard asset allocation. One problem is that the international shares exposure is almost all in the "international" basket which is half US and the rest UK/Europe and Japan. These areas have been poor performers over the past 10 years (mostly because of the "tech wreck" and also the poor Japanese market during the period). Personally I would much rather have a higher proportion in Emerging markets and less in the "old world economies" of the US/Europe.
Despite this, the mix of this fund would serve you well over 10-20 years as the core of your portfolio. If you stuck to this fund you wouldn't need to open a cash account or broker account. Just invest direct with Vanguard and set up a salary deduction straight into it. Very simple.
The main disadvantage is the fees - 0.90% pa is quite hefty compared to the cost of doing exactly the same thing yourself. The fee structure is tiered so even if you invest say $100k, the first $50k costs the 0.90% pa.
With very little work and much less cost you could invest in exactly the same underlying markets using an Australian ETF (STW or SFY) for the Australian share portion, then use US-listed ETFs for the rest. All major Australian on-line brokers access the US markets. It costs nothing to set up the US account via your Australian broker - and it uses the same linked cash account. With the US access set up you can invest in over 100 US-listed ETFs which cover just about every market and every sector in the world. Eg. you could use the following ETFs for the international portions:
IVV - ETF which tracks the US S&P500 index
EZU - which is ETF which tracks the European Monetary Union stock index
EWJ which tracks Japan
EEM - emerging markets (Brazil, Russia, India, China. Sth America, Sth-East Asia)
These have much lower annual fees - eg IVV has 0.10% pa fee. Look them up on a free US market site like www.bigcharts.com and type in the 3-digit codes. I have a chapter on how to invest in global ETFs like this in my new book - "$1million for life".
If you are just starting out with investing, the Vanguard fund is a great way to start - much more convenient and less paperwork!.
The usual warnings apply of course - make sure you read the PDS and be prepared for the normal ups and downs in the market. Make sure it really is for the long term and that you won't be needing the cash for 10+ years.
6.13 Education Savings Plans
"What are your thoughts on education savings plans and how will the they affect other savings accounts set up for the kids in relation to tax?"
I personally don't like education savings plans for a variety of reasons, including:
huge sales commissions - to get an idea of the commissions, try to get your fund to give you a payout/redemption figure if you closed the account today. You may find that you have lost 20% or 30% or more of your money in sales commissions.
high fees
poor investments - many are invested largely in cash & bonds, which are not appropriate for long term plans - 10years plus. Should mostly be in growth investments like shares or property trusts - using low cost, commission-free investments.
tax - they will tell you it's tax-free, but it's more like tax-paid. That means the fund pays the tax each year and you don't then pay tax again at the end. It's not tax free like the ads say.
also the tax rates are high. If it is run by an insurance company or friendly society (which most education funds are) the fund pays tax at 30% each year during the life of the fund. This is a much higher tax rate than most people could do themselves. Most families have an adult in low or nil tax brackets, and kids can earn up to around $2,500 in investment income before paying any tax, meaning they can hold up to around $50k in investments - each.
most funds restrict what the money can be used for - check the fine print in your fund.
As far as the second part of your question goes - If you have an education fund, the fund pays the tax each year, not the fund owner or beneficiary. So generally the fund's income and tax paid each year do not affect your child's (or your) income and tax for the year.
Don't get me wrong - having an education fund is better than not having any savings or investment plan at all. (I think most people spent their Baby Bonus on a new TV or car, etc !) But a huge chunk is lost in fees and commissions and unnecessary tax with many or most education funds.
When you get your current payout value you will need to decide whether to cut and run or stick with it. In many schemes the impact sales commission reduces over time, so it may pay to hang on until maturity or maybe a few years. If your fund is a regular savings plan where you make regular contributions, you may be able to stop contributions and just keep the existing money in there until maturity.
Of course these are general comments only - your particular plan might be very different - but I hope I have given you some questions you might want to ask your provider to help you make an informed decision. Also talk to your accountant if you have one, because most accountants will have some experience with education plans with other clients.
6.14 "Why don't the ETF prices keep track with the underlying index they are supposed to track?"
There are a few reasons why the returns you get from ETFs will vary slightly from the returns from the underlying index they are tracking:
1. STW and SFY charge an annual management fee of 0.29% pa, and SLF's fee is 0.40% pa - which comes straight off performance. In normal circumstances this will be the major cause of divergence between the ETF and the index it tracks.
2. other transaction expenses - mainly brokerage for buying and selling - are very small in an index-type fund. But over the past year or so there have been several large take-overs and therefore there has been an unusually large amount of transaction activity - needed to keep the portfolio matching the index weightings. Also an unusually large number of companies are seeing their share prices (and therefore their index weightings) change very frequently and dramatically (mainly mining stocks in this current boom). Means and increase in buying and selling activity to re-weight the fund - probably more than in a more normal market.
3. also a number of companies come and go from the index every now and then - which means buying and selling - eg News Corp (NCP) was dropped from the index a couple of years ago but is now coming back in as NWS. Means selling and buying and therefore unusually high brokerage cost.
4. timing - the index assumes immediate payment and reinvestment of dividends, which can take several weeks in real life. In the case of the property trust ETF (SLF) it is a real headache for ETF managers because distributions sometimes take up to 3 months to actually get paid in cash. But we as investors need to account for the distribution income on an "accruals basis" - because the security is a trust structure instead of a company, the investors count the income as having been received on "record date" not on "payment date" which often straddles the next quarter or year for performance measurement purposes. In a boom market we miss out on any market gains on the distributions during the period between record date and payment date.
5. There is also a buy "spread" when you buy your ETF units. This will depress performance of the ETF very slightly when comparing performance over time. The longer the time the less the effect (maybe 0.1% or 0.2% - but it's a one-off effect, not annually). In most cases the cost of the spread is very small. In STW the spread tends to be smaller than in the SFY because STW has traditionally had high volume of trades and better depth - that's one reason why I tend to use STW instead of SFY.
This cost of the spread is the same as with buying any listed security. Even unlisted managed funds have a built-in spread in both their "buy price" and "sell price" for units, which is meant to reflect the spread the fund manager has to pay when they invest the money in the market. In the case of unlisted funds, the spread they charge their investors is several times more than the spread they end up paying - the rest they pocket as profit.
6. I also find that daily moves in the index tend to take full effect only the next trading day in the ETF price. This is presumably because the ETF manager needs to know what the weightings are at the end of each day in order to adjust their holdings - mainly the next trading day in practice. In a booming market like we have been in for the past 3 years the ETF price and will often be behind the index by up to half a percentage point. As ETFs are increasingly used by institutional investors as hedging and arbitrage tools, this pricing difference will be eliminated as the market matures.
All in all, the Australian ETFs have tracked the indexes very closely - far better than most active fund managers - even before their fees and commissions. I expect the the efficiency to continue to improve as the funds get larger here. In the US the ETFs have sufficient size and systems to track the indexes extremely closely with very little "tracking error" (apart from the annual management fees, which are also much lower than even the 0.29% pa we have here).
In the US the big ETFs are the most actively traded stocks on in the market and their annual management fees are around 0.10% pa or even lower. In Australia we will probably see fees reduce further over time.
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