Faceoff: RESPs

Talbot Stevens, financial consultant and author of financial freedom without sacrifice

Stance: RESPs are effective, but not enough

Most Canadians hoping to educate their children are well served by RESPs. There’s always the risk that the intended beneficiary doesn’t pursue higher education, and the subscriber is taxed on the growth. But that risk can be largely eliminated if parents leave enough unused RRSP room—up to $50,000 of the RESP’s growth can be transferred to an RRSP.

Parents should start leaving some RRSP room once the child turns 14 to provide a buffer against any change in plans.

Exposure to risk also needs to be managed once the child gets closer to university. Over a 15-year period, the first 10 to 12 years of investments could be equity-based.

Following that, investors should consider tapering off risk and focusing on capital preservation.

TFSA vs. RESP

Unless clients specifically earmark the TFSA for education, they are likely to dip into it for emergencies. The 20% government grant offered on base-level contributions to RESPs makes the registered account more favourable.

Even those who don’t want to fund a child’s entire education can still put money into an RESP and later offer it as a loan to the child.

Clients should consider whether an RESP will be enough, especially given today’s trickling growth, higher tuition costs, and longer time spent in post-secondary pursuits. For these reasons, parents may need to supplement RESPs with non-registered savings.

Non-registered alternatives

Business perks:

Business owners can pay their kids to work for them. Up to $10,000 a year is tax-exempted income. Business owners have yet another option—employee scholarship plans.

They’re doable for a small, family-owned business, but only if the family owns 50% or less of the company. In eligible cases, the business can pay a tax-deductible scholarship directly to employees’ children. Because the scholarship is not paid to the employee, it isn’t considered a taxable benefit. The beauty of this plan is students can earn $3,000 of scholarship income tax-free, independent of RESPs or employment.

In-trust-for (ITF) accounts:

ITF accounts are available to all parents and allow them to invest in equities. While parents are taxed on the interest income, they are not taxed on the capital gains.

These accounts can be optimized by having the occasional capital gains taxed in the child’s name. Although the ITF strategy doesn’t have the grant benefit, it offers complete flexibility.

Parents rarely have to pay tax on interest or dividends with equity funds, making ITFs almost as tax-efficient as RESPs.

Leveraged investing:

Borrowing to invest is another possible supplement to RESPs for equity investors, but it can be controversial. If the markets do well, the magnified returns can net more than RESPs. And as with ITF strategies, there are no penalties if the child doesn’t pursue higher education. Because the investment is in the parents’ names, the funds don’t even have to go to the child.

Real estate:

Purchasing an investment property can be another interesting strategy for parents. It can dovetail well for those who like to put their own sweat equity into the mix. Buying property in the town where a child is likely to go to school can be ideal. The property can be rented to other students to generate an income. The child could also help manage the property and be paid a reasonable income, most of which might be tax-free after accounting for the basic personal exemption of about $10,000 and other deductible school expenses.

Child tax benefit:

The Canada child tax benefit (CCTB) is often overlooked. It’s money that technically belongs to the child, and can be invested in any way, compounding tax-free in the child’s name. The money could also grow in an ITF account.

Sara Kinnear, RESP specialist and Director of Tax and Estate Planning, Investors Group

Stance: RESP first, everything else follows

Parents who are certain their children will pursue post-secondary education should maximize RESP contributions first, then use a TFSA second, and finally look to non-registered accounts.

New RESP regulations alleviate many of the old woes. If one child doesn’t pursue post-secondary education, for example, the account can now be transferred to siblings who do.

Alternatively, subscriber contributions can be withdrawn tax-free. The 20% penalty on an accumulated income payment (AIP) can be avoided by transferring up to $50,000 of the AIP directly to the subscriber’s RRSP.

Another option is to withdraw the AIP in cash—subject to normal withholding and penalty—and gift it to the child, who can transfer it to her own RRSP.

Before an AIP can be made, certain conditions apply: the subscriber must be a Canadian resident; the plan must be at least 10 years old; and the beneficiary must be at least 21 years old and not attending school.

A new rule in the 2012 federal budget allows parents of a disabled child to transfer AIPs from that child’s RESP to his or her registered disability savings plan (RDSP), starting 2014. Most of the normal AIP conditions can be waived in these cases.

Ducks don’t line up

There are instances where RESPs don’t always work as intended:

• The child doesn’t pursue post-secondary education
• There are no siblings eligible to receive transferred funds
• There’s no RRSP room

In case of this triple whammy, an RESP could come out behind the TFSA, maybe even lagging non-registered plans.

But even those who don’t get an opportunity to use the government grant portion of the savings can still use the growth from that grant. The plan also remains a win-win for low-income clients, who are eligible for the Canada Learning Bond.

Surprisingly, according to a recent BMO study, the bond has very low uptake, with only 16.3% takers as of 2010. The plan gives eligible families an initial $500 contribution toward their child’s RESP—allowing them to open an RESP account without having to make their own investment—and deposits a further $100 annually to a maximum of $2,000.

Some are less equal

Not every Canadian qualifies—or benefits—from RESPs. There are specific conditions that apply:

The beneficiary must be a resident of Canada at the time the plan is established, and at the time of each contribution

There’s nothing in the Income Tax Act that requires the subscriber be a resident to open an RESP or make contributions. But in practice, the subscriber usually needs to be a resident, as financial institutions are often restricted from accepting funds from non-residents

If the subscriber moves out of Canada after setting up a plan, the account can be maintained but no new funds can be added

If a beneficiary becomes a non-resident of Canada for tax purposes, educational assistance payments can still be made, but cannot include any government grants or bonds and will become subject to non-resident withholding tax

A beneficiary is eligible for the grant and bond only up to the end of the year in which the beneficiary turns 17.

For that reason, immigrants with grown children may not find the account that useful. While an RESP account will still offer tax deferrals, a TFSA account could work better—and offer greater flexibility—in this case.

To make RESPs work, it’s best to have greater exposure to equities when the child is very young and start weaning off risk when she approaches her teens. At that time, it’s a good idea to rebalance the portfolio so that at least two years’ tuition is protected.

Alternative option

Minor accounts:

These accounts allow parents to gift money to a child who’s still a minor and invest it in their name.

While the child is younger than 18, parents pay tax on income earned, but not on capital gains. If the gift is invested in deferred-growth equities that generate capital gains rather than dividends or interest, it will be taxed to the child instead of the parent.

One critique of minor accounts is that once the child reaches the age of majority, she—not the parent who has made the contributions—decides how the money will be spent, and it may not be on education.

Kanupriya Vashisht is a Toronto based financial writer.