There was a time when only the wealthy or, at least, the well-off could sock away money in tax-deferred or tax-avoiding trusts for the benefit of children and kin headed to university. Today, registered education savings plans (RESPs) allow anyone to contribute to a child’s, a grandchild’s or anybody else’s child’s education.
These accounts are trusts in structure and operation and usually are held at banks, credit unions, mutual fund companies or specialty financial services companies that manage RESPs. The owner of the money is the planholder – until the money is distributed – and the beneficiary is the person or family of persons intended to receive the money. The keeper of the rules is, of course, the Department of Finance Canada.
The theory behind the RESP is that taxable distributions will be taxed in the hands of the recipient, who should be in a lower tax bracket than the contributor. That’s the upside.
The downside is that growth is treated as income when it is distributed. That means capital gains that could be taxed at half the rate in ordinary circumstances are potentially taxable at full rates when paid out of an RESP. However, only the income, not the return of capital, is taxed.
There are limits to how much can be contributed, however. The current limit for contributions to an RESP is $50,000 per beneficiary; a 1% monthly penalty is imposed for overcontributions from any source. If a family is intent on boosting the capital of an RESP, it’s a good idea to discuss who puts in what – lest penalties be triggered. The $50,000 limit applies to a period of 31 years after the plan is opened, or 35 years if the beneficiary is disabled. In either case, a plan can run for another four years, after which it must be wound up.
The Canada education savings grant (CESG), which adds the lesser of $500 or 20% of annual contributions, has restrictions. There’s a lifetime CESG limit of $7,200 payable to any one beneficiary. Contribution room for the CESG grows at $2,500 per year even if the child is not yet an RESP beneficiary. Catch-up contributions are possible within the $7,200 lifetime limit, subject to an annual limit per beneficiary of $1,000 – or 20% of unused CESG room.
RESP rules are loose compared with those for RRSPs. For example, RESPs have a lifetime contribution per beneficiary but have no annual contribution limit, unlike RRSPs. The temptation for a parent or another contributor is to make a large initial contribution, perhaps upon the birth of a child, in a plan’s first year in order to take advantage of what could be 17 years of tax-free growth before the child begins post-secondary education at age 18. But putting $50,000 into the plan in its first year would qualify for only one year of the CESG.
The CESG is payable until the child reaches age 18, so the concept of losing what could be 17 additional years of CESG top-ups to the $7,200 beneficiary limit would have to be compared with what the large, lump-sum contribution might earn.
The single contribution scenario provides speculative opportunity for an adept money manager, whereas the sequential contribution scenario is a form of investment-cost averaging with the 20% or $500 enhancement and, therefore, is less risky than a one-time, lump-sum contribution.
For most clients, it’s safer to limit annual contributions to $2,500 and take the CESG as an instant 20% return, says Graeme Egan, financial planner and portfolio manager with KCM Wealth Management Inc. in Vancouver: “It is hard to equal a stream of one-year annual 20% gains. And in down market years, it would be almost impossible – except for investors who have the skill and the guts to be bottom feeders.”
Quebec is a special case. That province adds a 10% refundable tax credit for contributions to an RESP. Known as the Quebec Education Savings Incentive, such RESPs can get a credit of 10% of contributions each year made in the year, up to a limit of $250. In effect, the rules, which are the same as those for the federal CESG, add 50% to the CESG’s annual value and limit.
However, if the intended beneficiary of the RESP does not pursue post-secondary education – or none of the beneficiaries in a family plan go to a qualifying institution – and if the plan has been in operation for at least a decade, then, if all the eligible beneficiaries are age 21 or older, up to $50,000 of RESP income can go toward a contributor’s or spouse’s RRSP – provided there is contribution room. This allows an RRSP deduction to offset the addition of RESP funds to income. If the RESP’s funds are not contributed to an RRSP, then a surtax of 20% of RESP income is imposed on top of the taxes payable on the income. In the case of group RESPs, contributions are returned, but the income earned stays in the plan to be distributed to plan beneficiaries who do pursue post-secondary education.
RESPs work well for the majority of students who need money and who won’t be in tax brackets higher than those of their plan’s contributors. Yet, the planning can be thrown off by summer jobs that pay well or by year mismatches if students take time off but have taxable RESP distributions in years in which they are working rather than studying. Thus, concept and reality may not mesh. Students should plan distributions with their planholder – usually a parent – as carefully as they pick their courses, suggests Derek Moran, president of Smarter Financial Planning Ltd. in Kelowna, B.C.: “Tax benefits and the CESG make RESPs a natural family investment. They are easy to start and run. But simple, they are not.”
The tax benefits of being a student
Recipients of registered education savings plan (RESP) money have full exposure to taxes on their income, but there are tuition fee tax credits to soften the blow.
Tuition fees qualify for a 15% federal tax credit, and a student who pays the tuition fees may be able to transfer that credit to a parent or another person. Along with tuition fees, other charges, such as application fees, exam fees, fees for certificates or diplomas, health fees and gym fees are covered.
Then, there’s a $400 federal education tax credit for each month of full-time attendance at a post-secondary institution in a program that must be at least three consecutive weeks long and require at least 10 hours of coursework each week. For part-time students, the tax credit is $120 a month for attending eligible programs.
For post-secondary students entitled to claim the education credit, there’s also a non-refundable textbook tax credit of $65 a month for students who qualify for the full-time education tax credit.
If a student cannot use all of these credits, up to $5,000 worth of the combined credits can be transferred to a spouse, parent or grandparent – or carried forward for claims against taxable income in future. However, carry-forwards can be used only by the student – they’re not transferable.
Although RESP payouts are taxable, a scholarship, bursary or fellowship income is not taxable if the related payments are connected to a program that allows the student to claim full-time education tax credits. All programs, up to and including a PhD and other doctoral programs, qualify; however, post-doctoral programs do not.
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