How can I invest for my children’s education?

Investing for your children’s tertiary education is most effective as a long-term goal, in the same way as investing for retirement works best over long terms.

You should start putting away money for your retirement many years before you are due to retire, yet many people either start too late, or fail to make any provision at all, for retirement and their children’s tertiary education.

If you do not invest for this goal, when the time comes for your child to go to university, college or any other tertiary learning institution, you will be at the mercy of funders or have to take out a student loan or sign surety for your child to obtain a student loan.

Funding can be hard to obtain and there are many reasons why your child may not qualify, from academic performance to your household income.

Consider the interest

When it comes to loans, there are pros and cons to taking a loan in your name or your child's name, but whichever one you opt for, you or your child will be paying interest.

If you invest, however, you will earn interest. And the sooner you start, the less you will have to invest because of the magic of compounding. Read more: Why compounding growth is so important

There are many ways you can invest for this purpose, but the most popular options are: an exchange-traded fund; a tax-free savings account; a unit trust fund or an education policy.

When you choose an investment vehicle, you must keep in mind how much time you have to invest, because your time horizon determines how much investment risk you can take. If you have 10 years, you can afford to take more risk than you can if you have only five years to invest.

Also consider how flexible the investment is should your financial circumstances change. While you should commit to your investment, if you are forced by circumstances to stop investing, you don’t want to face penalties for breaking the terms of a contract.

Also remember that education inflation is around three percentage points higher than consumer price inflation (general inflation), so you need a return on your investment that at least exceeds CPI plus three percent.

Education policies

An education policy is generally an endowment policy which pay out after a specified term that is a minimum of five years. These policies can, however, have a maximum term of 10 or 15 years.

You are contractually bound to invest a lump sum or contribute a set amount every month and do not have unfettered access to your money. Some providers may allow you only one withdrawal in the first five years and more after longer periods.

Some policies allow you to suspend contributions for a certain period, such as six months, and then impose a penalty if you are still unable to pay. These penalties cannot exceed 15 percent of your savings in the first year and must reduce each year, with no penalty after the fifth year.

Other providers allow interest-free loans against your savings if you need access to your money, but charge policy alteration fees.

If you fall on hard times and have to stop investing, you may be able to leave the investment as “paid-up” until the maturity date, when the investment pays out.

Your savings in an endowment policy are taxed at a flat rate of 30 percent. This means that these investments are only suitable for investors on a higher marginal tax rate. If you pay income tax at a rate of less than 30 percent, you will be taxed more in an endowment than in a unit trust investment, for example.

Endowment policies may be coupled with life and disability cover that pays the contributions or pays a benefit should you die or become disabled before you have saved your goal amount. This may be useful, but if you already have sufficient life cover, you may not need this additional cover.

Unit trusts

A unit trust investment offers you a simple and cost-efficient way to invest in a diversity of shares and/or other financial instruments such as bonds and listed property. Investing in these funds can provide higher returns over the long term than the interest you can earn on money in the bank. Read more: How can I invest in a unit trust fund?

To achieve the best returns that beat inflation, you need to invest over the long-term – five years or more. Investing for longer periods also smooths out the ups and downs or volatility that comes with investing in equities.

The beauty of unit trusts is that you can increase or decrease your contributions, add lump sums (should you want to invest a portion of your annual bonus, for example, or any money gifted to your children), and you can access your money in an emergency without incurring any penalties – because you are not contractually bound to an investment term as you are with an endowment policy.

There is a big universe of unit trust funds from which to choose, and your choice of fund must match your investment horizon. A good place to start investing is in a balanced or multi-asset fund, which aims to provide steady, long-term capital growth, by investing in a blend of assets (across the asset classes of equities, bonds, cash and listed property). Read more: Why are there different kinds of multi-asset funds?

Your unit trust will earn interest and dividend income, both of which will be taxed in your hands. (The first R23 800 of interest income you earn in any year is tax-free.) And when you disinvest, you will be liable for capital gains tax. Read more: How do I pay tax on my collective investment scheme?

Exchange traded funds

Exchange traded funds (ETFs) are listed investments and many are passively managed, tracking indices of shares across local or global markets. Some ETFs are actively managed portfolios. Generally index-tracking investments are cheaper than those that are actively managed.

If you invest in an index-tracking ETF you get to own shares or fractions of shares in some of the largest companies listed on a stock exchange.

ETFs, like unit trusts, spread your risk by investing in a range of companies giving you good diversification. Investing in an ETF that tracks an index for an entire market like the JSE, gives you a chance to own a piece of that market.

This diversification and the fact that ETFs are cost-effective and transparent makes them a popular option for first-time investors. ETFs have been available on the Johannesburg Stock Exchange since 2000 and there are now ETFs across all asset classes locally, and many offering exposure to global equity markets. You can invest in an ETF via a monthly debit order or a single lump sum investment, and you can buy and sell your ETFs at any time when the market is open, just as you would a share. Read more: How can I invest in ETFs?

Tax-free saving accounts

A tax-free savings account (TFSA) can include underlying investments that may be a a fixed-term bank account, a money market fund, a unit trust or an ETF.

TFSAs were introduced to South Africa in 2015 to incentivise us to save. And the incentive is considerable: You can invest up to R46 000 a year in a TFSA and R500 000 over the course of your lifetime and these savings can grow free of income tax, dividends tax and capital gains tax.

According to regulations, you must be able to withdraw your investments easily from a TFSA, and investment providers are not allowed to charge high penalties for early withdrawals. Read more: What do I need to know about investing in a tax-free savings account?

TFSAs are ideal for building wealth over time but remember that there is a life-time contribution limit and you cannot replace what you withdraw. If you think you may want to use the life-time limit for longer-term savings where the tax savings could be significant, you may want to think twice about using up the limit on education savings that you may access in the nearer term.

Remember too that if you exceed the annual limit, the taxman will charge you penalty tax at a rate of 40 percent on any excess contributions.

While you can open a TFSA in the name of each of your children, think twice before you do so. Firstly, that money will become theirs when they reach the age of majority (which is 18 in South Africa) and if they are not emotionally mature, they may squander it. Also, by opening a TFSA in their name, you will be using part of their allowance which will limit their ability to save tax-free in their lifetime.