Question: My son is 9. My daughter is 12. Both of them see a tidy amount of cash – about $1,000 a year – come their way through the odd birthday gift, chore money and grandparent contribution to their savings accounts. And I suspect the amount will rise in the coming years, once they are old enough to get babysitting and lifeguarding gigs and the like.
Up until now we’ve simply parked their cash into plain-vanilla savings accounts. There are no fees, but there isn’t any interest to be made either.
So, my question is: Where should we park their accumulating fortune over the next 10 years? They won’t need to access the money (the Bank of Mom and Dad will deal with any of their needs and wants). I’d just like to park their money in the most advantageous investment vehicle I can and simply forget about it until well into the next decade. And, of course, we would want to continue to contribute to this nest egg over the prevailing time with no fuss and no muss.
Benjamin Felix is an investment adviser with PWL Capital in Ottawa.
Answer from Benjamin Felix: There are two questions that need to be answered. What should your children invest in, and how exactly does a minor child go about investing?
Ideally, your children will invest their money in low-cost index funds. Based on the amount that I would expect them to be investing (less than $50,000) and the need to make ongoing contributions, TD’s e-Series index mutual funds are likely a great option.
There are also plenty of so called robo-advisers popping up in Canada that could fit the bill. In the context of investing, 10 years is not a particularly long time. The shorter your time frame is, the less risk you can take in your portfolio. Here are some suggested maximum stock allocations based on investment horizon.
Pick an allocation, buy some TD e-Series funds, and revisit the portfolio on an annual basis or whenever a new contribution is made.
However, the answer to the second question is more complicated. People are not able to enter into binding contracts until they have reached the age of majority in their province. If they cannot enter into a contract, they cannot buy investments.
The most sensible solutions to this problem include using a registered education savings plan (RESP), or setting up an informal trust account. Each option has unique tax and legal implications that are important to consider.
An RESP is designed to assist in saving for a child’s education. It achieves this through a combination of government grants and tax deferred investment growth. If you open an RESP with your child as the beneficiary, you still own the assets contributed to the account. When you contribute to an RESP, the government matches 20 per cent of your contributions up to a maximum of $500 per year. There are additional amounts available for lower -income households.
All investment growth inside the RESP is tax-deferred. If it is used as it is designed, the RESP will stay invested until the child enrolls in a qualifying educational program, at which point education assistance payments (EAP) can be made from the RESP to the child. With an EAP, the investment growth and government grants are taxable in the hands of the child, but the child is most likely paying little or no tax due to their minimal student income.
Each child gets a lifetime maximum contribution limit of $50,000, and only $36,000 of that will attract government grant matching. An idea might be for you to contribute the $2,500 per year that will attract grants, and use the remaining $14,000 of contribution room to hold the amount that your children want to invest.
If your children do not end up enrolling in a qualifying educational program, you can get the contributions out tax-free, but you will have to return the grants to the government. You will also have to pay tax on the investment earnings at your marginal rate plus a 20 per cent penalty. Unlike an in-trust account, your children do not have a legal claim on the assets when they reach the age of majority.
An in-trust account is an informal trust that is set up at a financial institution for the purpose of investing assets on behalf of a minor child. This gets around the inability of children to buy investments as the trustee is now able to direct the purchase of investments on behalf of the child.
An informal trust is created to avoid the legal and accounting costs of setting up a formal trust, but care must to be taken to ensure that the informal trust still meets the legal definition of a trust. When you contribute to an in-trust account, the minor child owns the assets but the trustee is in control. When the child reaches the age of majority, they can legally take control of the assets.
The other important consideration for an in-trust account is the taxation of the investments. Gifts given to minors by a family member will fall under Canada Revenue Agency’s attribution rules; if you give the child money and it is invested in an in-trust account, the income and dividends earned on this money will be taxable in your hands, not the child’s.
Attribution does not apply to capital gains, and it does not apply to interest and dividends earned on reinvested interest and dividends (second-generation income). Before you get any ideas, it’s not realistic to build a properly diversified portfolio that only earns capital gains.
Unlike an RESP, the in-trust account is not subject to any contribution limits or special rules for withdrawals.
A permanent life insurance policy can also be a vehicle to invest assets for a child. Some such policies have a savings or investment component built into them that allows you to add cash to the policy in excess of the cost of insurance, up to a maximum. The result is an increasing cash value in the policy, which grows tax-deferred over time.
The idea here is that the asset grows tax-deferred while the child is a minor, and ownership of the policy can be transferred to a child at a future date. The reality is that the cost of insurance is unlikely to be justified. Do your kids really need life insurance? Also, the investment options available in insurance policies do not tend to be great.
This strategy is unlikely to make sense unless you have already maxed out all available RESP room, and even then it is not something that I would get excited about.
If both you and your children are sure that they will not need this money in the short term, my advice is to first maximize use of the RESP. Once that is done, I would look into setting up an in-trust account.
If you build a portfolio using the TD e-Series funds, you should revisit it once a year to ensure that the allocations stay aligned with your targets. You can follow the Canadian Couch Potato’s model portfolios for TD e-Series funds in conjunction with the maximum stock allocations that I have suggested to design your portfolio.