Baby Steps: Investing Strategies For Minors

When it comes to investing, what is the most important thing? Asset allocation? Stock picking? Market timing? The answer is: None of the above. Historically, the best guarantee of good investing returns is simply time in the market. There are two, possibly three reasons for this:

1. Stock market returns skew upwards and to the right due to rising company revenues as a result of inflation and enterprise growth.
2. Money compounds over time where returns pile up on top of returns to create bigger gains during a longer horizon.
3. When funds are held in tax-free or tax-deferred accounts, and where there are minimal trading fees and commissions, the gains compound at a faster rate.

For these reasons, parents and grandparents who wish to invest in their children’s and grandchildren’s economic future, have a tremendous advantage in doing so if they start early. Very early.

Life Insurance

Though it may feel a bit creepy, there is no better time to purchase a permanent life insurance policy for a child than when that child is a minor. This is likely a time when the child has no medical history, therefore no red flags for a potential insurer. Today, we have access to a wide variety of medical diagnostic tests, from Magnetic Resonance Imaging (MRIs) to blood panels and DNA analysis. With rapid advancements in machine learning, the scope of diagnostic tests, both to screen for potential illnesses and to optimize health, is likely to explode. From a health optimization point-of-view, this is likely to be a net-positive. However, from an insurance angle, it means the test results will be factored into the cost of purchasing a life insurance policy, or, in a worst-case-scenario, being denied coverage all together.

A newborn is likely be in good health. Purchasing a policy for a newborn means being able to lock in favourable mortality rates for life and secure coverage at lower cost. A permanent life insurance policy, where the parent or grandparent is the policyholder and the child is the insured, can be used strategically to support Next Gen in a cost-efficient way.

First, the permanent life insurance policy provides lifelong coverage, locking in the child’s insurability in the event of poor future health. In addition, the Income Tax Act states that assets held within a tax-exempt life insurance product are not subject to annual taxation, and the proceeds from these policies are tax-free to the beneficiary. Part of each premium payment goes toward the policy’s cash value. As the cash value grows, it can serve many uses when the child becomes a young adult. For example, it can be used as collateral for a loan at a more favourable rate than what a financial institution would charge on a home equity loan or personal loan, or it can be partially or wholly withdrawn to fund a business investment, buy a home, or simply to supplement income. (Note: Withdrawals usually cannot be repaid, and they permanently reduce the death benefit. Plus, there may be fees and tax implications to making withdrawals.)

The earlier the policy is purchased, the longer the investments within it compound and, depending on interest rates and policy dividends, these can add up to as much as 50-to-80-per cent of the value of the original policy. Although each policy is unique, if a $1-million permanent life insurance policy is purchased for a newborn beneficiary, by age 30, they may be able to cash in up to $800,000.

Unlike opening an investment account on behalf of a younger family member, once a policy is purchased, it does not require any further management or time on the buyer’s part. It is a way to transfer some family assets to younger members in a simplified yet structured way.

Registered Education Savings Plan

If buying a life insurance policy is not your cup of tea, another useful strategy for parents and grandparents is investing in a Registered Education Savings Plan (RESP). This is a popular government-sponsored plan that matches eligible contributions that grow tax-deferred until the child uses them for educational costs. The funds can be used for anything related to secondary education including tuition for university, college, or trade schools, in addition to supplies, textbooks, living expenses, transportation, and computers, phones, and other technology.

There is a lifetime contribution limit of $50,000 per child which is eligible for a $7,200 lifetime maximum Canada Education Savings Grant (CESG) per child based on a minimum contribution of $2,500 per year. The Plan allows for an overcontribution of $14,000. Everyone likes free money but something to consider for families with the means to do so, is to invest the full $50,000 as a one-time lump sum and forfeit the government top-up of $7,200. Because the larger sum would compound over a longer period, it would result is the maximum tax-deferred return after 18 years. For example, based on an annualized 6 per cent return over 18 years, biting the bullet with a lump-sum deposit of $50,000 in Year 1 would result in a plan value of approximately $145,000 in Year 18 compared to $125,000 if payments were paid annually and included the government grant.

Upon withdrawal, the original contribution is not taxable, and the balance (grant, plus investment earnings) are taxable to the student who may pay little or no tax anyway, especially if withdrawals are made up to the student’s basic personal amount. Accounts can remain open for 36 years. If the child does not use the funds for education, they can be transferred to another child, or the contributions can be returned tax free and investment returns withdrawn and these would be taxed. Or up to $50,000 of the funds can be transferred into the subscribers (person who made the deposits) RRSP.

Trust Accounts

For higher-net-worth families, another way to build assets for minors is to set up an In Trust For (ITF) account. This is a taxable investment account that is opened by a parent or grandparent. The contributor deposits the cash or assets, an appointed trustee makes the investment decisions and the beneficiary, the child, receives the proceeds of the withdrawals. The advantage of an ITF is there is no contribution limit, and the use of funds is unrestricted. Capital gains are taxed in the hands of the child. Once the beneficiary reaches legal age (18), the trust ends. As with all trusts, the devil is in the details. Potential drawbacks could be income attribution back to the trustee or accountholder and a lack of suitability for very large amounts and complex estate planning. This is not a DIY project, so it is best to speak to an advisor on how to set one up.

Early planning is one of the best defenses against uncertain future economic conditions. Many family members are concerned about whether their children and grandchildren will be able to invest in quality education or own their own homes. These are some easy and affordable investing strategies to make the power of time work for the Next Gen.

Rita Silvan, CIM is a finance journalist specializing in women and investing. She is the former editor-in-chief of ELLE Canada and Golden Girl Finance. Rita produces content for leading financial institutions and wealth advisors and has appeared on BNN Bloomberg, CBC Newsworld, and other media outlets.