Planning for Education - Registered Education Savings Plan ( resp ) and the Canadian Education Savings Grant ( cesg )
(This page has not been updated to reflect the change in the capital gains tax rate from 66.66% to 50% - which would make the in-trust option even more attractive. This page should be updated sometime soon.)
Probably one of the biggest abuses perpetrated on well-intentioned Canadians has been the Registered Education Savings Plan, RESP, and most recently the Canadian Education Savings Grant, CESG.
Warning: What you are about to read flies in the face of what most financial planner's will tell you. If you crunch all of the numbers and take into consideration student loans and bursaries I expect we'll come to the same conclusions.
If you are unfamiliar with the details surrounding these plans, the two links below are probably the best sources of information for the Canadian Education Savings Grant, (cesg), and registered educational savings plans - resp's.
|The Canadian Education Savings Grant, cesg ,Web Page|
|Revenue Canada Registered Education Savings Plan, resp , Web Page - Guides, FAQ's, Forms|
Background: The RESP was created as a way for Canadians to save for their children's education without the growth being taxed under the regular attribution rules. Normally, when you give your child money and he or she invests it and it earns interest or dividends, this investment income is taxed as if you had received the income. It is "attributed" back to you. These attribution rules were intended to curb potential abuse by parents trying to slough off income to their children who are taxed at a lower marginal tax rate. However, if you give your child money via an RESP, these attribution rules do not apply.
If you are the sort of person who intends to fund your children's education through interest bearing investments such as GIC's and bonds, or through dividends, then ignore the remainder of this article and click here. The resp and cesg is probably the best way to go in your situation. If you are going to use equity investments such as growth mutual funds, then carry on.
We should note that most advisors will tell you that in the case of an RRSP, given the choice, you would leave your interest-bearing investments inside the RRSP and your growth investments outside the RRSP. The reason for this is that interest bearing investments attract tax outside the RRSP and growth investments don't. This reasoning can be applied to RESP's as well.
Previously the rules governing the RESP were onerous. If your child did not attend a qualifying institution (i.e. college or university), all of the growth: interest, dividends and capital gains went to the educational institution that you designated on your RESP contract.
A lot of money went to these institutions because children did not go to university. In the province of Quebec, almost half the population doesn't complete high school let alone go to university. The abuse started with the scholarship fund companies that made a business out of selling RESP's. Their salespeople would scour birth notices in the newspaper and call the parents of the newly arrived bundle of joy to set up an appointment to discuss this wonderful program. Typically one of the parents would fall prey to the salesman's convincing arguments - "You want what's best for your child don't you? You want your child to go to university don't you?" Then the next few minutes would be spent completing applications to purchase an RESP made up of short-term money market instruments and government bonds with a hefty management fee and sales commissions. Often these amounted to more than the parent would have paid in tax under the attribution rules.
So bright financial planners, seeing what was happening, suggested to these parents "Why don't you set up an 'In Trust' account and instead of purchasing short term money market funds and bonds which pay interest and attract tax - buy growth funds and don't sell them until the child goes to university and you need the money?" At first the client couldn't believe that you wouldn't pay tax on the growth. The planner would explain that under the income tax attribution rules, while interest and dividends are attributed back to the parent - capital gains are taxed in the hands of the child (or grandchild, nephew, niece, etc.). Then the planner would explain the "Generally Accepted Accounting Principle" the "Realization Principle" which essentially states that you don't count your chickens 'till they're hatched. Just as Revenue Canada will not allow you to deduct unrealized losses, you don't have to pay tax on unrealized gains.
One of the biggest advantages to this strategy was that should the child not attend university you keep the money in the family and the educational institution doesn't get a dime. The government, seeing what was going on - all of this money collecting in trust accounts, decided to change the rules to make RESPs' more attractive. Firstly they changed the rules about having to give the growth in the plan to the educational institute should the child not attend university. What they said was "You can have your money back and all of the growth. You don't have to pay the university but we want 20% of your growth as a special tax, and by the way, the remainder is taxed at your marginal tax rate." To make matters worse, dividend income and capital gains are treated as ordinary income in an RESP.
This wasn't enough to get people to stop putting money into "In Trust" accounts so in the last budget the federal government threw in the Canadian Educational Savings Grant (CESG) and said we'll give you a break. Whatever is left over after educational assistance payments have been made, or if your child doesn't attend a qualifying institution, you can transfer the income from the plan to your RRSP up to a limit of $50,000 or your RRSP contribution room limit, whichever is smaller (the rev can form is T1171, I have a copy here).
Wow! The government is going to give us money! What a bargain! Have you noticed lately that just about every financial institution is telling you how much it's going to cost your kids to go to school in the year 2010 and what a great vehicle the RESP coupled with the CESG is to help you pay for this? Pay close attention to Quarks' rule of acquisition #17 - "A bargain usually isn't".
I am going to show you that this is the case with RESPs' then you are going to thank me and your children are going to thank me.
10% Growth, $2,000 / year RESP Contribution plus Canada Education Savings Grant
10% Growth, $2,000 / year In Trust Contribution No CESG
Let's look at the two tables above. The one on the left shows what you would have in an RESP if you made the minimum contribution required to get the maximum CESG of $7,200. That amount is $2,000 per year for 18 years (starting before the child's first birthday), or $36,000.
The second column shows what you would have in an "In Trust" account with the same $36,000 investment. Both examples assume a 10% growth rate. It's obvious to everybody that $120,382 is better than $100,318 correct? I disagree. I honestly believe that nobody has crunched the numbers. I don't think that there is a single financial advisor in Canada who has taken the time and effort to see what happens to RESP money as it is disbursed. If they did, then nobody would be selling these things.
In Trust Option
Let's assume that a four year university program sometime in the future will cost $60,000. That's $15,000 per year for four years for tuition, books, travel, labs, food, lodging etc. At the end of the child's education we have this $99,675 to deal with. We are allowed to remove our contributions tax free. The contributions were $36,000. That leaves $63,675 that must be brought into income. The best possible scenario is that you have $50,000 RRSP contribution room in which case the amount that has to be brought into income is $13,675. If you are in the 50% marginal tax bracket, when you include the 20% penalty, the government gets $9,572 and you get to keep $4,103. If you had contributed the maximum amount to your RRSP each year the amount that you give to the government is $44,572 and the amount you keep is $19,103. If your child doesn't go to university you have this problem on $120,382 plus you have to pay back the $7,200 CESG.
With the "In Trust" option I am left with $70,299 if the child goes to school and $100,318 if he or she doesn't. If the child goes to school and at the end of university you decided to cash out of this, the child (not you) has to pay tax on the capital gain. A rough calculation is as follows. The capital gain is $70,299 - $25,307 (approx. adjusted cost base) or $44,992. Only 66.67% of this is taxable or $29,996. Using Ontario 1999 tax tables with only the basic personal credit tax owing on this is $5,553. The remainder of $64,746 stays in the family!
If the child didn't go to university and decided to cash in his $100,318 the taxable capital gain is calculated as follows: $101,318 - $36,000 = $65318 x .6667 = $43,548. The tax on this is $10,468 in Ontario using the 1999 tables and only the basic personal credit. This is what the government gets and the family keeps $89,850!
Next question - is $15,000 from an RESP better or worse than withdrawing $15,000 from our growth funds?
If the child lives in Ontario and pays $5,000 in tuition and attends school for eight months his or her tax payable would have been $256.72 in 1999. For the child who withdrew funds the capital gain is calculated as follows: $15,000 - $5,400 (cost) = $9,600 gain of which 2/3 is taxable or $6,400. Guess what, the child pays no tax and can transfer unused credits of $6,994 to his or her parents. To a parent with a $50,000 income, this is worth $1,696 in after tax cash. In most provinces there is also a student loan and bursary program. In Quebec, a single person not living at home with a $15,000 RESP income would receive $0 bursary (free money). The same person with a $6,400 income (In Trust option) would receive a $1,200 bursary.
Lastly, not all parents are comfortable with the idea of their children coming into a large sum of money at 18. They are concerned that the kids will go out and buy a Harley-Davidson or join some weird cult. My clients who feel that way keep the growth funds in their name but ear-marked for their children's education. Conclusion: Unless you are investing in GIC's, bonds and investments that pay dividends, stay away from these plans. They do nothing for you and could cost you thousands of dollars in needless taxes and lost bursaries. Not everyone will agree with me, but I've crunched the numbers starting at different ages and for various contribution levels. If you get a different result after you've crunched the numbers I'd like to hear from you.
Borrowing from Your RRSP
A perfect example of this is the new federal program whereby you may borrow from your RRSP to return to school. If you are going back to school, chances are you are not working and have a lower income than you will after you finish your education. Unfortunately, it is precisely at this time that you will have to repay your RRSP and not receive a tax return on the amount repaid. You can remove from your RRSP up to $10,000 per year up to a total of $20,000 over a four year period.
If we assume that it costs $15,000 to attend school per year and that $10,000 of it comes from your RRSP and $5,000 from other earnings, then an Ontario resident would pay no more than $2,000, or 14.5% in income tax (see Tax Calculator) . However when the same person returns to his or her $40,000 per year job we are looking at tax of approximately $10,000 or 25% in income tax (average tax rate as opposed to marginal tax rate). You have 10 years to repay the $20,000 borrowed from your RRSP. That's $2,000 per year. Assuming a marginal tax rate of 40% you lose 40 cents on every dollar by not being able to deduct these RRSP contributions.
To add insult to injury, you have to pay tax when you pull the money out during your retirement years.
It seems to me, that unless there are other circumstances at play, you are better to simply remove the funds that you need from your RRSP.
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