Sept 16, 2010
Most people desire to see their children become well educated, and given the burden of financing post-secondary learning, it’s no wonder education planning and savings has become a staple of the financial planning and investment industry.
Of course, the most popular method to save for education is the Registered Education Savings Plan (RESP). The benefits of an RESP are well known:
The government will match RESP contributions with the Canada Educations Savings Grant (CESG) at a rate of up to $500/year to a maximum of $7,200/child;
Up to $50,000 can be contributed over the child’s lifetime and can be taken back, tax–free, at any time; All growth is tax-sheltered;
Assets remain under the full control of the plan’s owner, such as a parent or grandparent; and When the child goes to school, withdrawals of the grant and gains will be taxable in the child’s hands.
As well, additional bonds and benefits may apply based on family income, the child’s year of birth and the province of residence.
But when a child decides to opt out of post-secondary education, things become a little more complicated. The owner of the plan will have one of two options: transfer the assets of the plan to an RESP for another child, or shut down the RESP.
Unfortunately, the latter option has repercussions: although the principal is returned tax-free to the owner, the government takes back the CESG amount. And while growth can be transferred to the owner’s RRSP tax-free, if there isn’t room, the full amount will be taxable at the owner’s marginal tax bracket plus an additional 20% tax.
It’s this last point that requires special attention. A tax penalty of 20% on top of one’s marginal tax bracket is no small sum. In fact, for investors in the top tax bracket, this 20% additional tax pushes their tax bracket on RESP gains to over 59% in every province.
It’s a steep price to pay, and one that begs the question: is a person better off investing inside or outside an RESP, in a tax-efficient structure like corporate-class mutual funds, when planning for a child’s future?
To illustrate the tax disadvantages of an RESP when a child decides not to pursue higher education, it’s a good idea to examine an investment strategy that’ll provide the maximum pool of capital for education. Take this scenario:
$2,500 is contributed into a new RESP in order to obtain the $500 grant;
$14,000 is contributed to the RESP;
$33,500 is invested in a corporate-class T-series fund designed to pay out $2,500 per year as return of capital.
This strategy requires some explanation. Why the additional $14,000? The reasoning is simple. The maximum lifetime CESG is $7,200. This grant is only paid out at a maximum rate of $500/year and requires up to $2,500/year of contributions in order to obtain the $500 grant.
Therefore, a person would need to contribute $2,500 for 14 years and an additional $1,000 in the 15th year in order to obtain the full $7,200. When this stream of payments is totalled, it equals $36,000. That means that there’s an additional $14,000 that can be contributed to an RESP at any time without affecting one’s ability to obtain the full grant.
Given investing within an RESP will provide tax-sheltered growth, it makes sense to make this top-up payment into the RESP.
The last element of this strategy is to park the remaining funds needed to maximize the RESP – $33,500 – in a corporate-class T-series investment and set it to pay out $2,500 in return of capital per year. The reasoning for this is straightforward: corporate-class funds are tax-efficient and yield tax benefits.
In this case, the benefits are that the $33,500 will grow, tax-sheltered, and will be taxed as capital gains at disposition. As well, by coupling this strategy with a T-series payout, it’s possible to transfer the $2,500/year of principal tax-free to the RESP in order to receive the full grant. This will continue for 14 years and then in the 15th year, the final $1,000 of principal will be transferred. The flow between the two accounts will then end. By executing the above strategy, the investor will have contributed the $50,000 RESP maximum, obtained the full $7,200 CESG and deferred all taxes through use of a corporate-class structure and the RESP.
If an 8% rate of return is assumed, following this strategy will see a child’s education fund grow from $50,000 at birth to $241,717 at age 18.
It’s true – not everyone has $50,000 sitting around to invest when a child is born. However, for the sake of this analysis, this amount illustrates how large one’s tax liability can become.
Dealing with the consequences
Let’s say not only does a child decide not to pursue a post-secondary education, but the plan’s owner has no other children and has already maximized his or her RRSP. That leaves the owner with only one option: to withdraw the funds and pay tax on the gains.
If this happens right at age 18, when the child would most likely begin a post-secondary education, the $241,717 would have an after-tax value of $139,741 (assuming Ontario’s 46.41% top marginal tax rate, the 20% additional tax, and the clawback of the $7,200 CESG). Alternatively, if the individual had invested the same $50,000 in a corporate-class mutual fund and earned the same return, he or she would have accumulated $215,785 before tax and $177,314 after tax.
Surprisingly, the RESP strategy actually loses in this case, with the non-RESP strategy coming out ahead by 27%. If the child had pursued a post-secondary education, there would have been an additional $25,932 to draw upon. But, having elected not to, the owner of the RESP is worse off than had he or she invested outside of one.
So where does this leave the sponsor of an RESP? While a plan owner can’t control a child’s education decisions, he or she does have one choice: when to collapse the RESP. An RESP can be open until the beneficiary reaches age 35. That means that the owner has the option of deferring taxation on these investments until that time.
Is that wise? It can be, for two reasons: Continued tax sheltering; The deferral of taxation to a year where the owner has a lower income.
However, delaying the collapse can sometimes actually worsen the tax situation, as the non-RESP strategy’s advantage continues to grow at a faster rate – so much so that at age 35, it’s 44% better.
The reason for this is while both strategies grow assets on a tax-deferred basis, the corporate-class strategy will eventually pay 23.205% of all gains, whereas the RESP account’s tax liability will pay 66.41%.
Making the call
It’s clear that RESP investing can have its disadvantages. That’s why:
If an RESP beneficiary doesn’t attend a post-secondary education, the investor is likely better off investing outside an RESP in a corporate class structure; If one faces the prospect of having to collapse an RESP, the best time to do it is as soon as possible. This, of course, will depend on the life choices of the beneficiary; and Investing an additional $14,000 in the RESP only worsens the tax situation in the event of the beneficiary not pursuing an education.
Does this mean one shouldn’t use RESPs? No it doesn’t, because if a beneficiary ends up going to school, the grant money and the growth it generates will be taxed in the hands of the student, who’ll have tax credits that will effectively result in their receiving payments tax-free. This windfall can’t be dismissed.
Unfortunately, no one knows what their children will decide. As a result, it’s probably advisable that only the amount required to obtain the full grant be invested within the RESP.
In setting up an RESP, a parent/sponsor is taking a leap of faith — one that could end up costing $37,573.