School’s in: Can your clients afford it?

Recent enhancements to RESPs, as well as the introduction of the tax-free savings account, mean rethinking education funding strategies for your clients. Let’s look at a few ideas.

Maximizing RESPs

With the annual RESP contribution limit removed and the lifetime maximum limit increased to $50,000, many clients wonder whether it’s better to make an initial lump sum $50,000 RESP contribution (and thus forfeit all future Canada Education Savings Grants) or maximize the grant of $7,200 by spreading out the annual contribution over approximately 15 years (14.4 years to be exact).

Let’s look at an example to see what the best option might be.

Your client Lisa just gave birth to a son, Noah, and has money set aside for his education. She has come to you asking for help in determining the best method of maximizing savings for Noah’s education. Should Lisa contribute the maximum limit of $50,000 today, knowing that she will collect only the $500 CESG for this year and forgo all CESGs in future years, or is she better off to spread the same $50,000 investment over the life of the RESP, collecting the maximum CESG possible?

If Lisa contributes a lump sum of $50,000 to an RESP, her contribution will attract a $500 CESG in 2009. Assuming an 8% annual rate of return, the value of Noah’s RESP at age 18 will be approximately $201,800.

If she chooses to spread the $50,000 over time to collect the CESG, she could invest the $50,000 into an in-trust for (ITF) account with Noah as the beneficiary. Each year, she will transfer $2,500 from the ITF into an RESP for Noah to attract the maximum annual CESG. Under this option, Noah will collect the maximum lifetime CESG of $7,200, and the value of the RESP after 18 years will be $108,370. However, after 18 years, the value of the ITF account will be approximately $109,500. Therefore, the combined value of the RESP and ITF account will equal $217,870.

From an asset accumulation perspective, Lisa is better off to invest the lump sum of $50,000 in an ITF and transfer money into the RESP on an annual basis to collect the CESG each year. As long as Lisa intends to use all of the RESP assets (including the contributions) for the benefit of Noah’s education, this would be a superior strategy compared to making a one-time lump sum contribution to the RESP.

Maximizing RESP and TFSA planning strategies

Practically speaking, not all of your clients have $50,000 set aside today that can be earmarked for a child’s education. Therefore, past practice suggests that clients should plan to contribute at least $2,500 per year into an RESP to collect the maximum annual CESG and invest additional funds into an ITF account with the child as beneficiary. As an alternative, the creation of the TFSA has made it more practical to set aside funds over and above the annual $2,500 earmarked for an RESP into a TFSA rather than an ITF. The TFSA offers clients more flexibility in accessing the funds as needed while protecting the savings from the long arm of the taxman. The only downside is that a TFSA cannot be established for a minor, and therefore the parents will need to utilize their own TFSA contribution room for this purpose.

For incorporated business owners: Establishing a scholarship program

Scholarships have always received preferential income tax treatment. In the past, scholarships were tax-exempt up to $3,000. Amounts received in excess of $3,000 were taxable to the recipient student. However, in 2006, tax rules were changed to allow scholarship income of any amount to be tax-free as long as the recipient student was enrolled in an educational program at a designated educational institution. Then in 2007, rules were once again changed to broaden the enrolment eligibility not only to include designated educational institutions but also to encompass both elementary and secondary school educational programs. These changes have created an opportunity for your incorporated business owner clients to pay out non-taxable scholarships to children of certain employees.

A private corporation is allowed to use some of its funds to fund a scholarship program. If the program is set up properly, the scholarship payments are tax-deductible to the company. But more importantly, the scholarship payments will not trigger a taxable employment benefit to the employee, nor would it be taxable to the student, as long as the student is enrolled in a qualifying educational program or in an elementary/secondary school educational program.

How can you help your clients achieve this preferential tax treatment and avoid any risk of the CRA assessing the payments as a taxable “employee benefit?” Advise them that the scholarship award payments need to be based on student merit and NOT on a relationship to the corporation’s employee. The CRA has taken the position that scholarship payments must be part of a plan to help “a certain number of children selected on the basis of their scholastic records or other achievement.”

In addition, the selection process should be approved by a board or committee of persons not connected to the company, such as schoolteachers. The program also needs to establish a minimum entry grade of at least 70% and should limit the number of scholarships awarded each year. Doing so will increase the likelihood that CRA will approve the scholarship plan and that you will thereby achieve the desired tax-efficient results. The advice of a qualified tax professional would be required to establish a scholarship program for any of your client’s corporations.

It’s always important to fully understand how changing tax rules alter the strategies we offer to clients. Keep these strategies in mind as you discuss education planning with your clients over the fall season.

Frank DiPietro, CFA, CFP, is Mackenzie Financial’s director of tax and estate planning.

(09/03/09)