Complement RESPs with in-trust accounts

Sometimes learning how to fund an education is an education in itself.

The foundation for this exercise is the Registered Education Savings Plan, but with the cost of post-secondary education continuously rising, make sure your clients aren’t fooling themselves into believing that blindly maxing out RESPs puts their children at the head of the class.

Quite to the contrary, well before reaching the maximum RESP limit, it may be prudent to allocate some dollars to an in-trust account. Humble though it may seem at first look, a trust for a minor child could provide significant tax benefits that can make the overall plan much more effective.

Deconstructing the RESP

Three core tax features make the RESP a valuable education savings vehicle. First, though not tax-deductible, contributions may be augmented through federal grant money, as well as from some provincial assistance.

Second, while inside the plan, the savings are entitled to tax deferral on growth and income earned. Assuming later schooling proceeds as the rules require, income recognition will be delayed for years or even decades.

Third, when grant money and investment growth are withdrawn as education assistance payments (EAPs), that growth is taxed to the student beneficiary, as opposed to the (presumed) higher marginal tax rate parent or grandparent contributors.

And remember those non-deductible contributions? That component can come back to the subscriber tax-free. Be careful though, as this could mean loss of future grants for a time [DASH] an important reminder that strategic coordination of contributions, investments and drawdown is a must for the RESP investor and advisor.

In-trust account for a minor

So how do the tax features of a trust compare to the RESP? In particular, how can an in-trust account for a minor work in coordination with an RESP?

As with an RESP, contributions come from after-tax funds. Annual income is either taxed to the trust (at top marginal rate) or attributed to the parent as “settlor” in trust law. A significant exception is that capital gains may be distributed and taxed to the minor child. And, attribution ceases if the settlor dies, or when the child reaches age of majority.

Clients also should be aware the CRA may require proof the account is managed as a true trust. Failing that, all income and related taxation may be treated as that of the settlor or trustee personally.

If a higher degree of control over trust funds is desired, including keeping the property in trust beyond age of majority, it may be prudent to execute a formal trust indenture document.

Clearly, matching government grant money is a strong incentive to invest in an RESP. These instruments, in essence, provide an immediate return of 20% or more on contributions.

Above the matching grant level, however, a trust alternative may be the preferred option, particularly when long-term equity investments are planned. Not only may capital gains be taxed to the child, those investments can also generally be rolled out at cost base to that child, further deferring tax on unrealized gains.

Had the same investments been held in an RESP, the earnings and growth would be completely deferred until withdrawal, but would be fully taxable as regular income to the beneficiary child (see, “RESP or In-Trust Account?” this page).

But should the child not attend a qualifying program (and assuming no sibling or subscriber RRSP rollover), all grants must be returned, and the subscriber will be taxed on the growth, including a 20% penalty tax.

Conversely, while an in-trust account is often established with the intention of assisting with later education, legally it need not be restricted to that purpose.

Doug Carroll , JD, LLM(Tax), CFP, TEP , is vice-president of tax and estate planning, Invesco Trimark Ltd.