By Coreen T. Sol, CFA

 

If experts can practice skills, none are more learnable than financial strategies. Understanding the differences between various tax shelters gives you the upper hand when it comes to investment strategies.

 

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 understanding the functionality and limitations of the program, you can benefit from this savings platform. It can act not only to defray the costs of post-secondary schooling but also to split taxes on family investments.

 

Money invested in an RESP is segregated into three categories. The grants and investment returns are separated from your original invested capital. The amount that you contribute to the plan is preserved as after-tax money. While there are no tax deductions for RESP contributions, there aren't any taxes imposed for taking your original capital back out of the plan. If you withdraw the capital prematurely, however, you will forfeit related grants. Once the grant money and accumulated income are distributed to the eligible beneficiary, though, you can remove your original investment as a Return of Capital (ROC) payment.

 

If your children are relatively close in age, there are meaningful benefits to opening a family plan, where all of the children are beneficiaries of the same account. That stands for grandchildren who are also close in age, rather than starting a separate plan for each child, designating multiple recipients on a single pool of assets to provide flexibility in allocating income to one child or the other during any particular tax year. If one of the children works during the year, shifting the amount to another beneficiary could reduce the overall taxes paid. The only limitation is that no recipient may withdraw more than $7,200 of Canada Education Savings Grant (CESG) over their lifetime. Also, each plan can only accept contributions for 31 years and distribute all of the assets after 35 years. For these reasons, it's impractical to assign children of widely varying agest to the same account.

 

Contributions of $2500 per year, for a total of $36,000, will receive the maximum CESG for a beneficiary. They can, however, contribute as much as $50,000 per beneficiary. If you have the money available, it may be beneficial to shelter it from high personal income taxes. Education assistance payments (EAP) is the withdrawal of investment growth, which is taxable in the hands of the beneficiary.

Grant eligibility accumulates from birth. Since 2007, each Canadian child is eligible for $500 of Canada Education Savings Grant (CESG) per year to the maximum of $7,200. Based on 20% of the first $2,500 contributed in a calendar year. For those who make less than $95,259 per year, however, benefits may be as high as $600.

 

The subscriber can collect these grants by making contributions until December 31 in the year that the child turns seventeen. Most families assume that maximizing the $500 annual CESG is the most lucrative use of the plan. After all, $7200 of federal subsidy isn't anything to disregard. Often, families jugging the expenses of raising children find it more feasible to contribute annually. In that case, maximize the CESG by investing $2,500 per year to collect the $500 annual grant is an ideal strategy. If they are starting late, CESG can be awarded for past years. Past benefits are capped at $1,000 per year until all uncollected eligible grants are exhausted. Also, subscribers who qualify with income under a particular threshold may receive the Canada Learning Bond. Also, some provinces, including British Columbia, Quebec and Saskatchewan, offer additional education and training grants.

 

For families who are on a tight budget, holding off on contributions in the early years is the best way to maximize the grant. In this way, capital is tied up in the plan for a shorter time. To be able to contribute to the program after the beneficiary is 15 years old, the subscriber must add $100 per year for four years, or $2000 in total. Then the subscriber can top up the plan with any amount up to $5000 per year and receive 20% of the contributed amount in CESG as the child plans for high school graduation. Collecting last-minute grants is a useful strategy for contributors who don't limited amounts to add but still want to maximize the awards. To obtain last-minute grants is particularly beneficial during the last few before the end of high school.

 

Surprisingly, however, the best way to maximize the benefits of the RESP is to forgo most of the CESG altogether. At 5% interest, contributing the full $50,000 to the plan and only collecting the first $500, accumulates about $23,000. The tax-sheltered compounding nature of the plan results in a much larger pool of accumulated investment than the typical strategy with regular contributions to maximize the CESG.

 

To flog the advantage of compounded returns over grant collection, if you were to stop contributing money once you collect all of the grants, you'd have deposited $36,000 over the years. If instead, you add that money upfront at a 5% return and forget most of the grants, you'd still have more than $11,000 more due to the power of compound interest.

 

To best exploit the benefits of this tax shelter, subscribers deposit the maximum $50,000 in the first year. At that same rate of return, the tax-shelter multiplies to $121,534, significantly more than the other approaches. The only reasons to contribute annually and collect the CESG each year is if the lump sum isn't available, or if your portfolio risk tolerance is low. In those instances, making annual contributions to collect the maximum grants is a better scheme.

Permitted investment in an RESP are similar to those for a Registered Retirement Savings Plan, so planning is essential. Equity portfolios are an option for a long-term investment horizon unless you have a low-risk tolerance. A balance of stocks and bonds is a more moderate approach, and investing in GIC's and other interest-bearing tools are the most modest methods with the highest guarantees. If the return on your portfolio is below three percent, however, compounding interest loses its potency, and the tactic to collect the eligible grants annually is more profitable. It is worthwhile to plan the timing and selection of your investments to find out what will yield the best outcome.

Contribution	$2500/yr	$ 45,000.00	$ 50,000.00
1	$ 3,150.00	$ 47,775.00	$ 53,025.00
2	$ 6,457.50	$ 50,163.75	$ 55,676.25
3	$ 9,930.38	$ 52,671.94	$ 58,460.06
4	$ 13,576.89	$ 55,305.53	$ 61,383.07
5	$ 17,405.74	$ 58,070.81	$ 64,452.22
6	$ 21,426.03	$ 60,974.35	$ 67,674.83
7	$ 25,647.33	$ 64,023.07	$ 71,058.57
8	$ 30,079.69	$ 67,224.22	$ 74,611.50
9	$ 34,733.68	$ 70,585.43	$ 78,342.07
10	$ 39,620.36	$ 74,114.71	$ 82,259.18
11	$ 44,751.38	$ 77,820.44	$ 86,372.14
12	$ 50,138.95	$ 81,711.46	$ 90,690.74
13	$ 55,795.90	$ 85,797.04	$ 95,225.28
14	$ 61,735.69	$ 90,086.89	$ 99,986.55
15	$ 67,657.48	$ 94,591.23	$ 104,985.87
16	$ 73,665.35	$ 99,320.79	$ 110,235.17
17	$ 79,973.62	$ 104,286.83	$ 115,746.93
18	$ 86,597.30	$ 109,501.18	$ 121,534.27

 

Withdrawing funds from the RESP begins when a beneficiary is ready for post-secondary schooling. Withdrawals come from the investment gains and the grant money that has accumulated. These payments are called Education Assistance Payments (EAP). The beneficiary is responsible for the income tax on the EAP at their marginal tax rate regardless of whether the funds are deposited to the recipient or the subscriber's bank account.

 

Initial withdraws are limited in the first semester to $5,000 for Qualified Educational Programs (QEP), and $2,500 for Specified Educational Programs (SEP). If costs are excessively high, you may apply for an exception. During subsequent semesters, however, there are no limitations on how much you can take out, as long as the student remains enrolled.

 

It is also worth noting that there are no requirements to submit expenses associated with schooling when making withdrawals. The only proof required is enrollment, 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 the savings.

Flexible withdrawals provide the family with options for investment planning and legal income splitting among their children. By investing in this tax-shelter, parents or grandparents reduce their tax burden by redistributing the income to someone in the family carrying a much lower salary and investment tax rate. Once the investment profit and grant money are depleted, the subscriber can remove their investment capital.

 

Naturally, the beneficiary forfeits the CESG if they don't use all of the amounts eligible for EAP. The remaining grant money must be returned to the federal or provincial government from where they were issued. When the plan closes after 35 years, the gains transfer to the subscriber as an Accumulated Income Payment (AIP). If the beneficiaries decease or suffer from a severe illness preventing them from attending post-secondary school, it can be closed early. That's also the case when the plan is open for a decade, the recipients are over twenty-one years old, and they are no longer eligible to withdraw an EAP.

The subscriber is taxed on the AIP payment at their tax rate plus an additional levy since these funds were invested tax-free over many years. The exception is when the subscriber has an unused RRSP contribution room. In that case, he can role the AIP into his RRSP.

 

The capital that remains in the plan is paid out as a Return of Capital (ROC) since original contributions always remain after-tax money. Capital withdrawals are tax-free.

 

For families who have limited funds to commit to savings plans, the RESP is a compelling alternative to the Tax-Free Savings Account (TFSA). It should be considered in coordination with other tax shelters available. It is best to seek advice on which tax shelter is best to allocate your savings.

 

Coreen T. Sol, CFA and Solinvest are Portfolio Manager and Investment Advisor with CIBC Wood Gundy in Vancouver, British Columbia. The views of Coreen Sol do not necessarily reflect those of CIBC World Markets Inc. Copyright Solinvest © 2020 http://www.cibcwg.com/cibc-disclaimer-viewer/marketing-view.jsp?viewId=22727