How to invest for a child using investment bonds

Give the gift of shares to a child through investment bonds, a tax efficient and flexible way to invest into the share market.

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Given the opportunity, who wouldn't like to go back in time and invest in the share market 25 years ago? If you had, compound returns from the market (10% on average) would have turned a meagre $10,000 in to more than $120,569 today?

This is one of the reasons why, as parents, we feel the need to start investing early for our children. That way, they too can enjoy the benefits of compound returns and learn about the wonderful wealth creation machine that is the share market.

This is where investment bonds come in.

What are investment bonds?

An investment bond, or insurance bond, is a product offered by an insurance company or friendly society. The bond combines an investment fund and a life insurance policy in one product.

A couple of features make insurance bonds ideal for investing for children.

First, investments are taxed within the fund at a 30% flat rate, separate from our own taxable income, which makes the product ideal for investors in a high tax bracket.

Second, the bond holder can nominate a beneficiary (anyone younger than 25 years old) to whom the investments will be transferred upon reaching a certain date or age. If held until "maturity", the investment bond will be vested in the beneficiary without any tax consequence.

How to use investment bonds to invest 

There are many insurance companies offering investment bonds, and all fund choices within are different. However, as a rule, the policy holder can choose between several funds both actively and passively managed, including from popular providers such as Vanguard and Blackrock.

Once you have gone through the registration process and the choice of fund, you need to make an initial contribution, starting from a few hundred dollars, then set up recurring monthly, quarterly, or annual contributions into the fund.

The funds can then be withdrawn after 10 years without any tax consequence, or any time before that date with some tax implications.

It sounds great. How much will it cost me?

There are a few different fees to be aware of.

The investment bond manager charges an annual management fee of between 0.3% and 2% based on asset under management.

The underlying fund provider – for example, Vanguard – charges a fee depending on the choice of fund plus some transaction fees, anytime additional fund units are purchased.

Some important rules to keep in mind

Investment bonds are "tax free" only if no withdrawal is made within the first 10-year period. This is known as the 10-year rule.

There is a further rule known as the 125% contribution rule, which requires additional contributions to be maximum 125% of the amount that was contributed in the previous year. This is set up to prevent tax avoidance.

Foolish takeaway

I believe the gift of shares to be one of the most powerful and rewarding gifts we can give our children. As parents, investment bonds offer us a good combination of ease of use, flexibility, and tax efficiency.

Motley Fool contributor Giacomo Graziano has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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