May 09, 2022Money Wellness Education Financial literacy Good reads
A Professional Strategy Sample: Using a RESP to Your Advantage
Financial strategies are learnable, repeatable and are reliably consistent in application. For example, a Registered Education Savings Plan (RESP) is a tax shelter flexible enough for more than just saving for your children's or grandchildren's post-secondary education. By navigating the functionality and limitations of the program, you can not only defray the costs of post-secondary schooling, as it was intended. You can also reduce the overall taxes on net family investments.
Money contributed to a RESP is segregated into three categories. Awarded grants and investment returns are separated from your original invested capital. Your contributions to the plan are preserved as after-tax money. While there are no tax deductions for RESP contributions, there similarly aren't any taxes imposed for withdrawing your original capital. If you withdraw the capital prematurely, however, you will forfeit related grants.
If your children are relatively close in age, there are meaningful benefits to opening a family plan where the beneficiaries are all connected to the same account. This applies to grandchildren who are relatively close in age. Rather than starting a separate plan for each child, designating multiple recipients on a single pool of contributions provides flexibility to distribute funds among the beneficiaries as needed. It is impractical, however, to assign children of widely varying ages to the same account, because each plan can only accept contributions for 31 years and must distribute all of the assets after 35 years from the date the plan is established.
Each beneficiary is eligible for Canada Education Savings Grants of up to $500 per year, and a maximum of $7,200 in their lifetime. It’s awarded to the RESP account based on 20% of contributions made to the RESP each calendar year. Subscribers who qualify with income under a particular threshold may also receive a larger CESG award, or the Canada Learning Bond, or both. Also, some provinces, including British Columbia, Quebec, and Saskatchewan, offer additional education and training grants.
Since the grants and income portion of the RESP are taxable in the hands of the beneficiary when they withdrawal funds from the account, shifting amounts between eligible beneficiaries can reduce the overall taxes. Withdrawals are restricted to either $2500 or $5000 (depending on the qualified post-secondary educational facility) in the first 13 weeks of their educational program, and $25,000 per beneficiary in any calendar year thereafter. Also, each beneficiary may withdraw only $7,200 of Canada Education Savings Grant (CESG) over their lifetime.
Most subscribers maximize the CESG by investing $2,500 per year to collect the $500 annual grant. You collect the grants with contributions until December 31 in the year that the student turns seventeen. If you begin contributing late in the process, CESG are still awarded for past years, to a maximum of $1,000 per year (up from the regular $500 annual maximum) until all uncollected eligible grants are exhausted.
Most families assume that maximizing the $500 annual CESG is the most lucrative use of the plan. After all, $7,200 is a generous federal education subsidy. To ensure that you receive the maximum grant, you can either plan contributions early or continue to make contributions until December 31 in the year that the beneficiary turns age 17.
These details are tedious, which is why professional advice is helpful in taking full advantage of the plan for your situation. Grants will only be awarded after the year in which the beneficiary turns 15, as long as contributions total $2000, or a minimum of $100 per year was added to the plan in each of the previous four years. This is to prevent abuses to collect grant funds immediately prior to post-secondary attendance. Although the RESP is designed for long-term savings, collecting these last-minute grants is a beneficial way to enhance educational funding with a modest financial commitment.
Since the amount of CESG awarded is 20% of the first $2,500 contributed each year, to a maximum of $7,200, that generally means that annual contributions totalling $36,000 will generate the most grant funding. However, you can contribute as much as $50,000 per beneficiary.
If you have the money available, the best way to maximize the RESP benefits is to forgo most of the CESG altogether. Instead of investing periodically to maximize the grant distribution each year, contribute the entire maximum of $50,000 all at once when the child is born. It is often advantageous to shelter these investable assets from high personal income taxes, and the sooner the better. Moreover, the returns on the $50,000 can result in a much larger value in the plan than the typical strategy to invest $2,000 annually to maximize the CESG. That is because more money is compounding at a faster rate than can be replaced by the grants awarded.
To emphasize this advantage of compounding returns over grant collection, compare two RESP investments. In the first, the subscriber deposits $36,000 when the beneficiary is born, collecting the first $500 grant and not collecting any grants thereafter. In the second plan, the subscriber contributes $2,500 per year over 15 years, collecting $500 CESG each year for a total of $7,200 in CESG. At a 6% return, the first plan will be worth $10,820 more. If the subscriber invests the full $50,000 when the beneficiary is born, the value grows to $114,175. That’s $42,473 more than the second subscriber who maximized the CESG.
The only reasons to contribute annually and collect the CESG each year are when a large lump sum isn't available, or your investment risk tolerance is low, and you don’t anticipate earning more than nominal returns. In those instances, making annual contributions to collect the maximum grants is a better scheme.
Withdrawing funds from the RESP begins when a beneficiary is ready for post-secondary school. Withdrawals from investment gains and grants awarded are called Education Assistance Payments (EAP). The beneficiary is responsible for the EAP's income tax at their marginal tax rate, regardless of whether the funds are deposited to the recipient’s or the subscriber's bank account.
The initial withdrawal is limited to $5,000 for Qualified Educational Programs (QEP) and $2,500 for Specified Educational Programs (SEP) over the first semester. If education costs are excessively high, you may apply for an exception. However, during subsequent semesters, this limitation is lifted as long as withdrawal don’t exceed $25,000 in a calendar year.
It is also worth noting that there are no requirements to submit expenses associated with schooling when making withdrawals. Proof of enrollment is the only requirement for withdrawing funds from the plan, and the beneficiary or the subscriber can use the money for any reason. Nevertheless, the expenses to attend these programs are high, and the costs of post-secondary pursuits can easily absorb most or all of proceeds of the plan.
Flexible withdrawals provide the family with options for investment planning and the tax advantages of income splitting among their children. By investing in this tax-shelter, parents or grandparents reduce their tax burden by redistributing income to other family members with lower tax rates. Once the investment profit and grant money are depleted, the subscriber can remove their original investment capital tax-free.
Naturally, a beneficiary forfeits the CESG if they don't withdraw it from the plan while attending school. The remaining grant money must be returned to the federal or provincial government from where it was issued. When closing the plan, excess gains may be transferred to the subscriber as an RRSP contribution, if they have the contribution room available. They may also elect to withdraw excess income as an Accumulated Income Payment (AIP), taxed at their marginal tax rate plus 20% since the funds were sheltered from tax since the inception of the plan.
The remaining capital is paid out as a Return of Capital (ROC) since original contributions are after-tax money. Therefore, capital withdrawals are tax-free.
For eligible families, the RESP is a compelling alternative to a TFSA due to the enhanced benefit of available grants. Financial strategies, such as the allocation of your wealth between various tax shelters including TFSA, RRSP, First Time Home Savings Plans, and RESPs, are learned processes that can be applied to amplify benefits to you and your family. Managing complicated tax shelters is possible for anyone to learn, if you’re keen. Outsourcing this expertise helps to ensure you’ll maximize its benefits while reducing the time and stress of deciphering the rules of engagement.