If you’re in a position to invest RESP funds for the education of your student, make sure that you do your homework.
Maroney on Money for August 31, 1997
This week the media proclaimed that annual post-secondary tuition fees increased by up to 18%. And it gets worse, that is, if you believe some of the studies floating around. For example, in 1992 the Directory of Canadian Universities predicts that the average cost for a four year program at a Canadian university will be $54,000 in the year 2000, $96,000 in 2010 and $193,000 in 2020.
If these studies prove to be accurate the hallowed halls of academia will become the hollow halls of academia. Even the precious few who could afford to attend a post-secondary school would be left questioning whether the return on their investment could justify the expense. Although I don’t expect tuition fees to increase at anywhere near the rate predicted, I’m confident that the cost of an education won’t be getting any cheaper. So what is a poor, beleaguered parent to do?
The traditional option has been to invest in a Registered Education Savings Plan (RESP). RESPs have been on the skids in recent years so the federal government has sought to breathe new life into this old standby. Starting in 1997, the annual RESP contribution limit has been raised to $4,000 per beneficiary, subject to a cumulative limit of $42,000. There is no tax deduction for RESP contributions. The advantage is found in the tax-deferred compounding. In other words, the income earned inside an RESP is not subject to income tax until it is withdrawn by a beneficiary. Since the beneficiary is likely to be a poor student, such income will likely be subject to tax at the lowest rate or, better yet, not taxed at all.
One of the perennial drawbacks to RESPs has been the loss of the income portion of the plan if you run out of qualifying beneficiaries. RESPs have a finite life of 25 years. At the end of this period you will be able to get your initial contributions back without tax, however, you may find all of the earnings within the plan going to the educational institution of your choice.
This issue was partially addressed in last February’s federal budget that proposed to introduce a “bail-out” option. This provision can be invoked provided the RESP beneficiaries are over age 21 and the plan is at least 10 years old. Of course, the government never gives anything away for free. Using this “bail-out” option will attract a special 20% tax above and beyond your regular tax rate. This could increase the overall tax on the RESP income to 74% in BC.
This additional 20% tax can be avoided by transferring the RESP income to your RRSP provided, of course, you have sufficient RRSP contribution room available. Since logic suggests that you should maximize your RRSP first before considering an RESP, this transfer option will only be available to those who have made a financial planning mistake in the first place.
Are there alternatives to RESPs? Absolutely. And in my opinion, these options are superior to RESPs, if only for the sake of the flexibility they provide.
If you are currently receiving the Child Tax Benefit, you have a great opportunity to split income with your children. Rather than simply spending your Child Tax Benefit, consider investing it in the name of your child. The nature of the investment is basically wide open. In this way, any income earned on the invested sum will be taxable to the child. Since your child is unlikely to be taxable now, or for many years to come, the investment will continue to grow tax-free. It’s hard to beat that.
There is one potentially serious drawback though. Junior has the legal right to the investment when he or she turns 18. Teenagers and adults frequently disagree on the best way to spend money so be warned. You may want to involve your child in managing the investment at an early age. This way your child will tend to view the investment as the cumulation of considerable time and effort rather than a windfall.
A second alternative is to simply give money to your child to invest. With this alternative, you’ll need to watch where the funds are invested. Interest and dividend bearing investments will generate income that will be taxable to the gifting parent. Clearly, this is not a wise choice.
Investments yielding capital gains are a different story. Since capital gain income will be taxable to the child, you’ll want to consider your investment options carefully if this is your chosen alternative.
If you’re in a position to invest funds for the education of your child, make sure that you do your homework.
Jim Maroney is a chartered accountant with Brown, Giesbrecht & Maroney in Maple Ridge.
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