Scotch College

Building wealth while funding your child's education

As we all know, providing a quality education for our children is expensive. Schooling has become competitive and the value of a quality private education cannot be underestimated. The threat of government cutbacks to funding seems ever present and the cost of living continues to increase, so it is critical parents take all necessary steps to build wealth to ensure they can meet their commitments. So what can parents do to build wealth in a tax effective way to pay for education expenses?

Many people are attracted to education type products. Many of these products provide a simple solution to saving for a child’s education. However, they are not entirely necessary if you can effectively build your own education portfolio. Doing this provides more control over the type of investments and the eventual use of the assets accumulated.

“Gearing” is a term used to describe the use of borrowed money for investment purposes. By adding borrowed money to an investment it is possible for an investor to significantly increase (or decrease, i.e. the losses are magnified) the return on an investment, assisted by the tax deductibility of interest payments. Where the interest on borrowings exceeds income from the investment, this is described as “negative gearing”. All income from negatively geared investments is assessed for income tax in exactly the same way as any investment portfolio. The difference with gearing is that the investor can deduct from their total assessable income, the interest on the borrowed funds as well as other expenses. Generally, interest is deductible in the year that it is paid.

The most common investments that are negatively geared are real estate, shares and unit trusts.

Assuming you borrow $250,000 in an investment which brings you 3% in income and you have to pay 7% in interest, this leaves you with a 4% shortfall you need to fund yourself. That is 4% of $250,000 or $10,000. This interest shortfall is tax deductible, so a top tax rate payer would receive a tax refund of $4,850. So for $429 per month after tax you could have $250,000 working for you. Over 10 years this could grow to $407,000 (assuming a growth return of 5%). Based on various assumptions, we calculate that contributing $42,000 over 10 years could achieve an after tax return of $120,000 – 3 times your initial outlay.

It is important that investors have adequate income to meet their loan commitments in the event there is a shortfall in income from the geared investment. To maximise the benefits of gearing, investors should have a high taxable income so they may write off their losses.

Managing risk

As with any strategy, it is important that the risks are managed, because, as we know, something can always go wrong. We can do this in a number of ways:

• By never borrowing up to our maximum amounts (i.e. allowing for a buffer)

• By locking in some of the loan at today’s low interest rates

• Ensuring we have adequate insurances to cover us if we cannot work

• Buying quality long-term assets

• Spreading the risk by diversifying some of your investments

Advantages of this approach

• An effective means of wealth accumulation

• Purchase larger investments than would be possible if using own funds only

• Reduce income tax liability (see taxation)

• Potential to achieve investment returns greater than returns that could be achieved without gearing

Although there are a number of issues around gearing which should be understood by you before proceeding, undertaking an “education fund” by gearing into a portfolio of assets can have some significant benefits. As we all know, quality comes at a price. The key is to set out a plan well in advance of when you will need the funds.

Who are we?

Donohue Financial Planning has been providing financial planning advice to Melbourne families since 1966 and is the Victorian Office of Western Pacific Financial Group.

Western Pacific was formed in 1985 by a group of Australia’s top financial advisers who had the common vision of developing a non-aligned financial services group with a national presence.

Today, Western Pacific has over $1.2 billion worth of funds under advice and morer than 10,000 clients around Australia. Although reasonably large, Western Pacific remains 100% owned by senior advisers and managers.

In addition to building quality investment portfolios, Donohue Financial Planning provides a range of other financial planning services – cash flow planning, tax planning, estate planning and risk management.

Donohue Financial Planning are an OSCA Key Supporter. For more information contact Donohue Financial Planning on 9824 0001.

As with all investment strategies, negative gearing may not be suitable for your particular circumstances, especially for some retired investors. You should consult your financial adviser before making personal investment decisions.