Funding a child’s education

A good education doesn’t come cheap. Even when counting subsidies, the costs of studying and living as a student can reach a small fortune. So many parents look for ways to save for their kids’ education even before the children are out of diapers.

The key to smart saving is to start early. It’s easy for clients to get caught up in immediate parenting duties and forget to take steps that will eventually help their child pay for education costs.

“You want to get the power of time on your side,” says Dennis Tew, CFO at Franklin Templeton Investments. “And if there’s more than one child involved, it’s going to be even more of a burden if you don’t plan ahead.”

The most obvious option is the Registered Education Savings Plan (RESP), an investment account meant to store money for a child’s studies after high school. There’s no annual contribution limit, and the lifetime limit is $50,000 per child.

Payments made are eligible for free money from Canada Education Savings Grants (CESG). For every dollar up to $2,500 invested into an RESP each year, the Government of Canada will contribute 20%—so the maximum annual grant amount is $500.

For low-income families, an additional CESG payment above the basic amount is available. If they miss contributing one year, parents can contribute up to $5,000 and receive up to $1,000 in grants the following year.

More grant money for low-income families

• Families with incomes of $41,554 or less qualify for an extra 20% payment on contributions of up to $500 per year (40% altogether).
• Families with incomes between $41,554 and $83,088 qualify for an extra 10% payment on contributions of up to $500 per year (30% altogether).
• The maximum lifetime amount the CESG provides is $7,200.

Liquidity in an RESP is restricted, similar to other long-term investment accounts. They’re solely intended for education costs, so if the child chooses not to pursue education after high school, the investment earnings within the RESP will be subject to a client’s regular income tax level, plus 20% when accessed for other uses.

Clients will get back their RESP contributions tax-free, but must return all grant money to the government.

What if they don’t go to school?

• A client will not be taxed on the amount contributed to the RESP, but will have to pay taxes on the money earned in the plan as interest. This accumulated income will be taxed at a client’s regular income tax level, plus an additional 20%.
• The money put into the RESP is returned to the client.
• The Canada Education Savings Grant can be shared with a sibling if there’s grant room available—otherwise, the grant must be returned to the government.
• When a client closes his RESP, he will have to pay tax on the earnings.
• A client can reduce taxes owing by transferring accumulated income to either his or his spouse’s RRSP.
• The RESP can last 36 years, should a child decide to go to school later in life.

RESPs also have restrictions on how they can be used—for instance, they do not apply to certain out-of-country educational programs.

TFSA works too

The Tax-Free Savings Account (TFSA) is another option. A TFSA offers a de facto educational savings solution because it has few liquidity restrictions and offers tax-free investment growth. With a yearly contribution limit of $5,000, the TFSA is no slouch. A June 2011 RBC research report found 16% of Canadians are using their TFSA accounts to save for their children’s or grandchildren’s education.

Tew suggests the TFSA is superior to the RESP once parents have maxed out the free grant money because the TFSA’s flexibility and structure make it a more efficient use of resources. “The money that’s in [the TFSA] is compounded tax-free so you can be more aggressive,” Tew says.

Should private school tuition or public school incidental fees crop up before the child gets to post-secondary education, clients can take money out of the TFSA to pay for those expenses without penalty.

In-trust accounts

An in-trust account is an arrangement that can be set up to manage assets for people who can’t do it themselves, in particular minor children. While it may not have the detailed instructions contained in a formal trust document, it can nonetheless be used as an effective savings vehicle.

Historically, one use for these accounts has been for parents and grandparents to save money for a child’s education. It can also be a great place to put financial gifts for birthdays or graduations. In-trust accounts suffer from a high degree of ambiguity, however, because they are established without a written document formally delineating the terms of the arrangement.

Any first-generation investment income such as interest or dividends in an in-trust account will be taxed in the account holder’s hands, with a few exceptions such as when the funds come from the Canada Child Tax Benefit (CCTB) or from an inheritance.

Money made from reinvesting first-generation income and all capital gains are taxed in the hands of the beneficiary child. Since the child is usually in a lower tax bracket than the contributor, this can create a favourable income-splitting scenario, though the Canadian Income Tax Act does specify situations where the capital gains might be taxed back to the contributor, including cases where the donor maintains control of any property or other investments held within the account.

While the name can be misleading, in-trust accounts are not trusts of any kind. Assets within an in-trust account are the property of the child for whom it’s intended and will be his or hers at the age of majority. That poses an interesting moral dilemma, since that money, originally intended for educational costs, could suddenly be used for a new sports car.

Formal trusts

For families with more resources, formal trusts offer a tax-efficient solution with an unmatched degree of customizability and control. In exchange, the set-up costs are greater and more maintenance is required.

Formal trusts differ from in-trust accounts by offering a more flexible structure. The settlor (i.e. the provider of the trust assets) specifies exactly how and when the funds can be used.

Investment income is taxed within the trust, although it’s possible to allocate taxable income to a beneficiary, subject to attribution rules. The investment policy can be specified in the trust deed and there is no contribution limit. Formal trusts, meanwhile, are always managed by a trustee as specified directly in the trust deed.

A beneficiary does not draw funds from a trust—the trustee distributes them, either by a set schedule or discretion established by the terms of the trust. A formal trust can thus restrict a child’s access to the funds by clearly outlining exactly how the funds are supposed to be used. This gets around the infamous sports car problem.

With a formal trust, only income paid or payable to a beneficiary, subject to attribution rules, is taxable in the hands of the beneficiary. In practice, though, formal trusts set up by a living settlor are taxed in the flat top marginal tax bracket, and thus generally allocate all income and gains to the beneficiary.

Clients who open formal trusts will incur set-up fees and trustee fees to manage the account; and a T3 tax return must be filed on behalf of the trust account. Legal and accounting costs also increase with the number of beneficiaries and the complexity of the trust.

Stanley Tepner, first vice president and an investment advisor at CIBC Wood Gundy, suggests that because of the flexibility and peace of mind they offer, formal trusts are a good option for wealthier parents.

“[After getting RESP] grants, if you have additional cash, create a formal trust because it gives you the most flexibility,” Tepner says. But you should do your homework. “The investment dollars involved should be substantial enough to justify incurring the legal and accounting costs.”

Can’t take it with you, can’t get it back

Regardless of whether clients pick a formal trust or in-trust account, any contributions they make to them are gone from their personal coffers for good. Putting money into a trust or in-trust account effectively means the donor has disposed of the funds.

Setting up a revocable trust to allow reclaiming of funds would defeat the tax advantages of setting the trust up in the first place. “When you’re making that contribution into a formal trust or in-trust account, treat it as if you’re giving that money away,” Tew says.

Lee Ann Davies, head of retirement strategies at RBC, suggests advisors take care of parents before their kids. “When you get to retirement, you need to have enough money to keep up your lifestyle,” she says. “Your children will have many years to pay off any loans they take for education—you don’t want to jeopardize your retirement savings to put them through school.”

Changing asset allocation

As with any investment portfolio, asset allocation is crucial. When the child is still young, a higher percentage of equity risk is acceptable due to the longer time horizon.

When the child gets to high school, the majority of the portfolio should shift towards short-term bonds, high-interest savings accounts and other low-risk products in preparation for the money to be withdrawn within four years.

Unlike most investment portfolios, the exact date of withdrawal is easy to estimate (usually the age when your child is expected to enter post-secondary schooling), an advantage that rewards vigilant and thoughtful asset allocation. “The closer you get to using the money, the less risk that money should be exposed to,” Tepner said.

Target-date funds can also provide simple plug-and-play alternatives. They involve a template that front-loads riskier equity investments and winds down to a more conservative allocation as the target date nears.

For parents who prefer to manage their own allocation with their advisor, it’s important they not get squeamish about investing heavily in equities in the early years. Emphasize to them that after a child’s born, parents have an 18-year time horizon to save.

Raf Brusilow is a freelance journalist and writer based in Toronto.