Investing to help children or grandchildren get a headstart on future education expenses can be a good idea, but make sure you consider the pros and cons of the different options.

As proud parents of two small children, my wife and I recently discussed setting up education funds for our kids.

Tertiary education doesn't come cheap – some 20 years after graduating from my first degree, the debt was only cleared a few months ago. To avoid this long-term expense and help children harness the power of compounding, many parents or grandparents like to establish some form of investment vehicle for their children.

But what's the simplest and most effective way to go about this?

With two children to raise and full-time work, we needed something relatively low-maintenance – which arguably rules out direct shares.

A managed fund might seem a logical option, but with so many to choose from, and initial investment amounts that usually range between $5,000 and $25,000, that may not be viable either.

Managed funds also require an adult to be the legal owner, as you need to provide a tax file number to open one.

It is possible for them to be held in trust for a child, but there are tax implications for the initial owner.

Chris Bates, principal of financial advice firm Wealthful, suggests younger couples with children, who may already have a mortgage, are better served paying any spare cash into their home loan before establishing a separate investment vehicle – whether to save for a child's education expenses or other any other reason.

Pay off debt then redraw

Bates believes paying down debt as much as possible before investing is usually a more sensible option.

"In that case, the best strategy is to pay that money off the home loan, and use the equity in the home to build a portfolio for shares.

"If you're going to set aside $20,000 per year, you're better off putting that $20,000 in the home loan…it's like buying an investment property, but negatively gearing shares instead," Bates says.

He sees many other financial advisers who direct clients keen to establish an investment for their children's education into separate products – but is sceptical about the wisdom of this in many cases.

"I don't like seeing that – all too often, it's just a way of selling yet another product onto someone, which binds them even more firmly to that particular adviser," Bates says.

Financial adviser James Gerrard, of Financial Advisor.com.au, suggests these products are suitable only if you're saving for longer-term education needs, not to pay for earlier schooling expenses. This is because only very small amounts of investment income can be withdrawn before large tax expenses kick in.

"So as such, they're really only worth a look for parents who want to use them for their child when they're over 18 years of age," he said in a recent episode of The Money Café.

There are only a handful of companies who provide these vehicles in Australia, including:

  • Austock Life Limited
  • IOOF WealthBuilder
  • Australian Unity Lifeplan Investment Bond
  • AMP Growth Bond

Note: these products are not researched by Morningstar or in any way endorsed by them.

For parents who may have already paid off their home loan, or perhaps grandparents wanting to invest on behalf of their children, products such as investment bonds may make sense.

Investment bonds are a type of investment-savings plan, and because earnings are taxed within the bond at 30 per cent, they’re considered ‘tax-paid’ investments.

This means you don’t have to worry about declaring the earnings you’ve made on your annual tax return. If you already have to pay a higher rate of tax on your income, they could be a tax-effective way to invest and save.

Investment bonds often suit long-term investors because they’re typically designed to be held for at least 10 years. While you are able to access your money before that, this may have some tax implications.

These products are often popular as ways of saving for a child's education expenses because they can "vest" into their ownership when they reach a certain age.

They also enable a beneficiary to be nominated, so they automatically pass into a third-party's ownership, tax free, if you pass away.

Earnings on investment bonds are generally not taxed if you hold onto them for at least 10 years.

While the tax-paid feature of investment bonds mentioned earlier can make them tax-effective if you're paying substantially more than 30 per cent in income tax – if you're not paying much tax, these products may not make sense.

Exchange-traded funds are another option that Bates likes for this type of savings goal, because of their simplicity, low-cost and diversification benefits.

Though their underlying assets are stocks, ETFs are much simpler to trade than individual stocks, as they are essentially a basket of individual listed companies.

A passive ETF lets you buy a collection of stocks that track the performance of a specific market index.

He points out the recent war on prices between Australian ETF providers Vanguard, iShares and Betashares. These can be purchased online from several brokers including those operated by each of the four big banks, or non-bank brokers such as CMC Markets and Bell Direct.

In our case, given we're still saving for a home along with paying all the everyday costs associated with raising children – childcare expenses in particular – we've held off setting up an investment until later.

But after discussing the idea with our parents-in-law, they've decided to front the cash themselves, and instead let the money build up in a standard bank account in the children's name.

Investment bonds might make sense later, but given their current tax situation, there isn't any real benefit to using such a product.

The longer-term plan here is to build enough capital to then invest in a higher-return option such as a managed fund or ETF.

Potential advantages of investment bonds

  • If you’re a high-income earner, it may be a tax-effective way to save over the long term
  • Money can be withdrawn from the investment bond at any time
  • Any growth or income earned will not need to be included in your annual tax return, as investment bonds aren’t subject to personal tax assessment until you make a withdrawal
  • If no withdrawals are made in the first 10 years, any profit on a withdrawal made generally won’t incur tax, as earnings are taxed within the bond along the way
  • They often offer a range of investment options to cater for different goals and risk appetites
  • They may be useful for people who are unable to contribute to super
  • They can be an effective way to save for a child’s future, including education
  • You can name who you want the proceeds to go to after you’re gone, tax free.

Potential disadvantages of investment bonds

  • Any income or capital gains that are derived are taxed within the bond at up to 30 per cent
  • Profits on any withdrawals within the first 10 years will be taxed at your income tax rate, with a 30 per cent tax offset
  • If you contribute more than 125 per cent of your previous year’s contribution, the 10-year investment period will begin again
  • Some investment bonds have minimum balances that must be maintained, so check out individual product documents for details
  • Investment bonds charge fees which can vary depending on the provider and options
  • They can be somewhat illiquid - though you can theoretically access funds at any time, it's usually not as simple or quick as extracting money from other investment types or accounts
  • An investment manager will be making the day-to-day investment decisions, meaning you won’t have direct control over the decisions made.