Putting The RRRRR! In RESPS – What to Do If Your Kids Aren’t Too Cool for School, Part 2
In this second installment in my series on how to pay for junior’s degree in ornithology or whatever other educational pursuits float their boats without hopefully jeopardizing your own retirement, I will focus on the most common strategy: Registered Educational Savings Plans (RESPs). As I wish to focus as much of my time on how to squeeze as much out of these plans as possible, I won’t provide you with a comprehensive catalogue of all things RESP, noting that there are many great resources out there to do just that.
All the same, to understand how to get the most of RESPs, it is vital to understand the basics. To begin, it’s possible to contribute up to $50,000 per child into an RESP, either in a stand-alone plan for that child or as part of a family plan for all your children. Although there are technically no limits regarding how soon you can invest the full $50,000 in contribution room, the government only provides 20% matching through what it calls Canada Educational Savings Grants (CESGs) on the first $2,500 contributed each year (i.e., $500 in yearly grants), up to a lifetime max of $7,200 in CESG grants per student, although here are also additional funds for low-income families I won’t discuss further. As one exception, if the family hasn’t made its full $2,500 in yearly contributions in the past, the government will provide an additional 20% matching on the next $2,500 in catchup contributions made in that year.
Unfortunately, —and this is a big drawback—any contributions that do not trigger government matching in the year of contribution cannot be carried forward to earn CESG grants later. In other words, CESG grants are based solely on how much has been contributed that year, with no credit for extra contributions made in years gone by. Accordingly, each family needs to decide what is more important; maximizing CESG grants over the lifetime of the plan or getting as much in the RESP as soon as possible to maximize tax-deferred compounding. As a result, as we all love free money, or have other things we can do with money that won’t receive government matching, most families are content to cap contributions at $2,500 per year (ignoring any catchup contributions) even though this means that it will take almost 15 years to max out government matching and that they will have far less money compounding in the plan than might have otherwise been the case.
Once inside the RESP, the person funding the plan (the subscriber) decides how to invest all the contributions and grants, with essentially the same investment choices that are available within a Registered Retirement Savings Plans (RRSP) or Tax-Free Savings Accounts (TFSA). All the money inside an RESP is commingled and grows tax-free. Upon withdrawal, the CESG grants, income and investment gains from all sources are lumped into a single category called Educational Assistance Payments (EAPs.) These are taxed as income in the child’s hands, assuming that child is enrolled in a full-time educational program of more than 13 weeks, with special rules for students with disabilities and part-time students. On the other hand, the original contributions from the subscriber, called Post-Secondary Education Payments (PSEs) are tax-free withdrawals and can either be paid to the student or returned to the subscriber, with the subscriber deciding which way to go.
When it is time to make withdrawals, it is also the subscriber who decides when, how much and what portion shall be taxable EAPs or tax-free PSEs. There are no restrictions regarding when the tax-free PSEs are withdrawn once the student is also eligible to withdraw taxable EAP payments. For EAPs, there a few more limits, but not that many. First, EAP withdrawals are capped at $5,000 during the student’s first 13 weeks of a full-time program ($2,500 for a part-time student) during a calendar year. In other words, a regular student attending school full-time until graduation with only summers off will only be capped during the first 13 weeks of their studies, as they will always have attended school for 13 weeks within the last 12 months.
Also, the student must be deemed a Canadian resident, or they will need to repay CESG grants, although studying abroad doesn’t necessarily mean losing Canadian residency. You will need to investigate this in advance if junior has Harvard in their sights. Ultimately, if the student become a non-resident, the previously paid CESG grants will need to be repaid and the EAP will also be subject to Canadian withholding tax of up to 25%, depending on junior’s new country of residency. The only other limit is a yearly cap for receipt-free EAP withdrawals. This limit will be $24,676 for 2022 and is indexed to inflation. Withdrawing more than this amount is possible but means justifying the extra expenses to the plan administrator.
If there is extra EAP money left when the child has completed their education, the subscriber can roll up to $50,000 into their RRSPs if sufficient contribution room remains, but without getting a tax deduction on the transfer. If there is another student in the works, it may be possible to use some of the remaining EAP for that person’s studies. Otherwise, the remaining EAP balance is taxed in the subscriber’s hands as income at their marginal rates with an extra 20% tacked on, which means an effective tax rate of over 70% in some cases! Accordingly, as I discuss below, I strongly suggest focusing on withdrawing taxable EAP payments as soon as reasonable to limit the chance of this unpleasant surprise at a later date.
Although I will now focus on the promised RESP maximization strategies, I just wanted to provide a final caution that I’ve vastly oversimplified things. You will need to read up on the background details on your own or get your financial advisor to fill in the missing pieces, as well as summarizing the pros and cons of each of the strategies below that apply in your situation. Caveats aside, here are my suggestions:
Is The CESG Grant Worth The Sacrifice?
Decide whether it’s worth trying to maximize the $7,200 in lifetime CESG grants. Although free money is a wonderful thing, this particular windfall comes at a cost: many years of lost compounding of investment gains inside the plan, since maximizing government grants means delaying full funding of the plan until the child is 15. Accordingly, some advisors recommend contributing the full $50,000 per child as soon as possible after cutting the umbilical cord and forgoing all but the first year of government matching. Assuming a plan grows at six per cent per year, a max-funded plan would grow by $3,060 in its first year per year vs. $180 for a plan capped at $2,500 in contributions. In other words, the extra sheltered growth in the first year is already more than the next five years’ worth of CESG grants and this disparity will continue to grow as the RESP grows.
Of course, it is essential to consider what else you could do with the money rather than filling up the RESP. For example, the money might be better deployed filling up TFSAs or RRSPs, paying down debt, or putting the money toward the other educational funding strategies like permanent life insurance, in-trust accounts, or a family trust. There is not a simple one-size-fits-all answer to this riddle, but it remains a question worth asking. In some cases, filling up the RESP strategy as soon as possible may make more sense for grandparents with disposable funds and OAS / estate tax concerns who are interested in leaving a legacy outside their Wills rather than moms and dads saving for their own retirements.
As a final thought, if there is a good chance that the student may no longer be a Canadian resident when it’s time to start withdrawing RESP funds, the CESG grants will need to be repaid anyway. Accordingly, for those students, it’s far more important to get as much money working inside the plan as soon as possible than trying to maximize government grants the student may not get to keep anyway.
Contemplate a $14,000 Bonus Contribution.
If max-funding an RESP ASAP isn’t appealing, or possible, consider at least making an extra $14,000 one-time contribution instead. It won’t affect CESG grants but will increase the money inside the plan available to compound. This is because the lifetime funding limit is $50,000 but grants are offered only on the first $36,000 of contributions. Accordingly, no matter how you slice it, it is impossible to get full matching if you fill up a child’s RESP to the bursting point. As a result, if you’re confident that you will be able to keep making regular $2,500 yearly contributions going forward and have the funds available, consider putting in this extra $14,000 as soon as possible, as it won’t affect CESG grants and increases how much money is in the plan to compound. On the other hand, before even making these bonus contributions, carefully consider whether this is the most tax efficient use of your money. For example, if you haven’t maximized TFSA or RRSP funding, investigate these alternatives as well.
Stick The Wealthier Parent With The Bill.
Have the higher income parent fund the plan even though it often makes sense for both parents be joint subscribers for estate planning purposes. That potentially frees up more of the lower income parent’s money to invest in their hands at their lower tax rates, which means more money for everyone, except the government.
Avoid Estate Hassles By Having The Right Person Contribute.
If grandparents want to assist, consider gifting the money to their children and then having them making the contributions on behalf of the grandkids to avoid estate planning hassles, since RESPs don’t have beneficiary designations. On the other hand, if worried about the children’s marriages, investment acumen or financial situations, grandma and grandpa may decide to become the subscribers despite the eventual estate planning hassle. If they make this choice, be sure to include proper language in their Wills specifying what happens to the RESPs and who will manage them, as RESPs are generally considered to be an asset of the deceased rather than property of the student. I typically include language instructing executors to continue managing the RESPs for the students and using it for its intended purpose when the time comes. By the way, the need to mention RESPs in a Will is true for anyone named as a subscriber, not only those in their 70s, 80s and 90s.
Mix It Up As University Approaches.
Make changes to the RESP asset mix as the child gets closer to university. In particular be strategic about realizing gains inside the plan around that time and rebalancing toward less volatile investments as the time approaches to start withdrawals. I don’t want any of my clients to have to liquidate RESP funds during a market dip just because the correction coincided with junior’s first tuition payment. Accordingly, holding boring but safer investments for at least the portion of the RESP the student may need over the next year decreases the chances of unpleasant investment surprises and the need for the student to eat far more Kraft Dinner than was originally anticipated.
Talk To A Lawyer Or Accountant If A Move Is On The Horizon.
Get tax advice if you are planning to move abroad while funding an RESP, particularly if moving to the U.S., to determine whether it makes sense to maintain the plan and to ensure that investments inside the plan aren’t subject to extra U.S. taxation, particularly if holding Canadian mutual funds.
Be Careful And Ask Questions If A U.S. Citizen Living In Canada.
Although RESPs may still be worth doing if you’re a U.S. citizen living in Canada, particularly due to the CESG grant, it’s worth getting expert advice before setting the wheels in motion, especially if the future university attendee may become a non-resident while studying nuclear fusion or Elizabethan poetry and are thus forced to repay CESG grants anyway. The U.S. doesn’t recognize RESPs, which means that a U.S. citizen subscriber will continue to declare and pay tax on gains and growth inside the plan. As a result, it makes sense for a non-U.S. citizen spouse to be a subscriber, although if you’re currently a single American who wants to set up an RESP for your kids, this isn’t a reason to take your romantic relationship with the nice Canadian down the street to the next level. Instead, this may be one of the times where tapping a grandparent or other relative who doesn’t have Uncle Sam concerns to be the subscriber if possible. If the RESP is already in place or there is realistically no one else who will be the subscriber, U.S. citizen subscribers owning Canadian mutual funds or Exchange-Traded Funds (ETFs) inside the plan may at least want to stay clear of such investments, since these investments are set up as trusts and the US taxes foreign trusts rather aggressively.
Finally, if you are a U.S. citizen subscriber of an RESP but you have someone else without American ties who is willing to be a subscriber to a new plan, you can have them set up a separate RESP for the lucky child. Future contributions and grants can be funnelled into that plan instead, thus lowering your own future tax bill. Although it is possible to set up as many plans as your heart desires for any aspiring architect, the lifetime CESG grant limit of $7,200, and the $50,000 contribution limits must be shared across all plans set up for them. As a result, it is vital to ensure that the overall funding limits are never exceeded. To hopefully avoid this problem, tell whatever financial institution is administering the new plan how money and grants were paid into the original RESP when the new plan is created. You may also need to tell whoever is administering the old plan about this as well, which might also include instruction for them not to apply for the CESG grant for the current year if money was contributed to both plans to avoid unintentional double-dipping.
Withdraw The Tax-Free Portion As Soon As Practical.
Consider withdrawing the tax-free PSE from the student’s RESP if they qualify for EAP payments as soon as practical. If the subscriber wants the money back, investigate withdrawing the funds on the way back from dropping junior off at school for the first time. If intending to give the money to the student, make the withdrawal as soon as (s)he reaches the age of majority in their province of residence and can open their own investment account. Putting the money into a non-registered investment account, TFSA or the pending first home buyers registered account may provide far more flexibility, lower taxes and better overall results rather than letting it sit in the RESP. Although there are a lot of great advantages to RESPs, the fact that every taxable withdrawal is taxed like interest is not one of them. Assuming you trust the student, having the unused PSE funds invested in the child’s name in a non-registered account can make the money go further, since investments generating dividends and capital gains will now benefit from these tax advantages. In fact, in provinces such as BC, eligible dividends taxed in a starving student’s hands may put money in their pockets, as the dividend tax credit in the lower tax brackets is larger than the tax owing on those dividends. The extra tax credit can be used on the taxable portion of RESP withdrawals or even allow additional withdrawals without incurring tax. As an extra bonus, since we ultimately do not want any taxable income left in a RESP when the student is done school, reducing future taxable growth inside the RESP by pulling out PSEs ASAP can help guard against the scary tax bill that might otherwise occur at a later date.
Use Tax-Free Withdrawals To Fund The Student’s TFSA.
Instead of investing PSEs in a child’s non-registered account, consider using some of the RESP withdrawals to start filling up the student’s own TFSA instead. Not only will that money grow tax-free, but any later withdrawals will increase the student’s tax sheltering room for later in life. Just be sure to consider the costs in setting up and maintaining the TFSA. In some cases, it might mean waiting until the student has a few years’ worth of contribution room before the potential tax savings outweigh the administration costs.
Use The Tax-Free Withdrawals Yourself.
As another alternative, consider using the money for your own or your other children’s registered plans. If the subscriber has unused RRSP or TFSA room, they may wish to take back their original contributions and use the money for those purposes, particularly if it appears that the student won’t need all the RESP funds to complete their education, or they are using other educational funding strategies to help with those costs. If the family has younger children who haven’t received all their CESGs, mom and dad may even want to use the money withdrawn from the older child’s RESP to contribute to the younger child’s plan so that they essentially get CESG grants on the same money twice while freeing up more of their funds for other purposes. On a related note, even if not the most tax efficient solution, having the subscriber invest the money rather than the student may be the right choice for some families if junior isn’t that great managing money.
Withdraw The Taxable Money Aggressively But Strategically.
Try to draw down the student’s taxable EAP money as soon as reasonable without paying too much tax along the way. Since the tax bill on any income and grants left inside the plan after graduation can be subject to scary high taxation, getting the money out sooner rather than later reduces the likelihood of this nightmare scenario. Likewise, if there is a chance that the student may complete part of their education abroad and lose their Canadian residency status, getting more EAP money out before that happens can also mean huge potential savings for the family. It isn’t like the student necessarily needs to spend the money right away. As noted earlier, the student can invest the money in their own name instead, which can offer additional tax savings vs. leaving it to grow in the plan.
On the other hand, keep an eye on the student’s taxable income from other sources before deciding how much EAP dough to withdraw. It usually makes sense to keep the student in the lowest tax bracket for their province of residence. By reviewing the student’s expected taxable income for that year and the year ahead, you can better decide how much EAP to withdraw, and when. For example, a student who worked full-time or had two co-op terms in one calendar year may pay less taxes if there was a big EAP withdrawal the following January but a far smaller one this year, even though it means not drawing down the taxable portion as soon as possible.
Use The Money to Contribute To The Student’s Tax-Free First Home Savings Account.
As of January 2023, people who haven’t owned homes during the last five years (i.e., most students) will have the option to contribute up to $8,000 per year to a new account that provides the best features of both a RRSP and TFSA – the ability to deduct contributions for tax purposes and the right to withdraw the money tax-free later if used to purchase a first home. The deductions may be carried forward if the student doesn’t have enough income to use them up or expects to be in a higher tax bracket soon or could be used to pull more taxable money out of RESPs tax-free or at a lower rate. If the family is planning to help with the first home purchase one day anyway and has the means to help the student with educational expenses along the way, getting as much money as possible into the student’s TFSA and First Home Savings Accounts to start compounding now is worth investigating immediately. Since there is no cap on how much can be withdrawn from either account, unlike the RRSP Homebuyers’ Plan that is capped at $35,000, getting the money working asap might be the difference between a bachelor suite and the penthouse.
Double Check That You Aren’t Mistakenly Withdrawing Too Much CESG From Family Plans.
Be extremely careful regarding CESG payments allocated to each student in a family plan. The main drawback to these plans is that it is possible to mistakenly pay out too much in EAPs to the older children and trigger penalties. EAP payments are a blend of profits and government grants (CESGs), while each student can only receive a maximum of $7,200 in CESGs. As any EAP payment is a blend of those two portions determined by a convoluted government formula, it is very difficult to know when a student has reached their CESG payout maximum. Plan administrators are responsible for tracking this on your behalf, but mistakes are easily made. Accordingly, review how much that student has already received in CESG payments with the institution and whether the planned withdrawal will put the student offside before making any withdrawals.
Conclusion
Although RESPs are a wonderful savings vehicle for many children’s educations, knowing how to get the most out of them can be the difference between good and great. Due to rising costs, particularly if junior wants to study in place where hockey and maple syrup are not staples of life, RESPs may not be enough to completely fund every child’s education. However, these plans may not be able to fully finance every student’s full education, particularly in light of the funding and CESG grant limits. Accordingly, parents, grandparents, uncles, and aunts may want to consider other ways to fund educations as I briefly summarized in the previous article, and which I will describe in more detail in the days and months to come.
Colin S. Ritchie, BA.H. LL.B., CFP, CLU, TEP and FMA is a Vancouver-based fee-for-service lawyer and financial planner who does not sell investment or insurance, just advice. To find out more, visit his website at www.colinsritchie.com.