RESPs should be part of your game plan if post-secondary schooling is on the horizon

Maroney on Money for September 15, 2001

In my last article I reviewed a number of different approaches frequently used to accumulate the funds needed to finance a post-secondary education. This week I’ll elaborate on one of these approaches – the Registered Education Savings Plan (RESP).

Up until a few years ago, RESPs weren’t high on the recommendation list of many financial planners due to restrictions placed on the use of invested funds – basically the tax-deferral carrot wasn’t considered significant enough to offset the inflexibility of RESPs. But the playing field has changed in recent years and RESPs should be part of your game plan if post-secondary schooling is on the horizon.

As the name implies, RESPs are designed to encourage saving to finance post-secondary education. The RESP “encouragement” comes in the form of a tax-deferral on investment income earned by the plan – investment income earned by the RESP is not subject to tax until the funds are withdrawn from the plan.

RESPs and RRSPs are frequently confused because of this “tax-deferral” feature common to both plans. Beyond this, RESPs and RRSPs are very different and should not be confused. The RESP is a plan designed to assist with post-secondary education whereas the RRSP is a plan set up to fund retirement.

The RESP contribution is not deductible for income tax purposes unlike the RRSP contribution that is, as we all know, deductible in calculating taxable income. When funds are withdrawn from an RESP only the income earned on the funds originally contributed will be taxed– logically, because no deduction was provided for contributions that went into the plan, there is no tax to pay when these contributions are withdrawn. Contrast this with RRSP withdrawals that are fully taxable because a deduction was provided for the initial contribution.

An RESP comes into existence when a subscriber enters into a contract with a promoter naming one or more beneficiaries to the plan. Where one beneficiary is named to the RESP, there is no requirement that the subscriber or beneficiary be related; in the case of multiple beneficiaries (referred to as family plans), the beneficiaries must be related to the subscriber (child, grandchild, great-grandchild, brother or sister) and under the age of 21 when named as a beneficiary to the plan. In the majority of cases the subscriber is a parent or grandparent and the beneficiaries are children or grandchildren as the case may be.

For each beneficiary, the annual contribution limit to an RESP is $4,000 with a lifetime limitation of $42,000. There is no provision for catch-up contributions – if you miss making a contribution in a given year, you’re out of luck. Not surprisingly, a punitive tax exists to discourage over-contributing to an RESP – a situation that can arise where there are multiple subscribers (e.g., parents and grandparents) contributing for the benefit of a single beneficiary.

You can contribute to an RESP for a maximum of 21 years, however, the plan can stay in place for as long as 25 years after which it must be wound-up.

When setting up an RESP you can choose to join a group plan or go it alone and set up a self-directed plan. Clearly, a self-directed plan gives the subscriber greater say into how the funds are invested. Self-directed RESPs are normally established through either a financial institution or a brokerage house and there’s a good chance you’ll be charged an annual administration fee to keep the plan in place, although no-fee plans do exist.

While there are restrictions on the type of investments that an RESP can hold, the rules mirror the qualified investment rules for RRSPs (yet another source of confusion between RESPs and RRSPs). Bonds, T-bills, term deposits, mortgages, publicly-traded stocks and mutual funds are all eligible investments under the RESP rules. There is no foreign content limit for RESPs unlike RRSPs where foreign content is restricted.

When deciding on the investment mix to hold in your RESP, bear in mind that the objective is to accumulate funds to finance someone’s education. For this reason, it’s logical to limit the risk of the investment portfolio – it makes little sense to me to speculate with RESP investments if you’re truly committed to the goal of building an education nest egg.

Distributions of income from an RESP, known as Educational Assistance Payments (EAP), can be made to a beneficiary once he or she becomes a full-time student at a qualifying post-secondary institution. Full-time study requires the student to spend at least 10-hours per week on courses or programs that last at least three weeks. The list of qualifying post-secondary institutions is broad and even includes institutions outside Canada.

There is no requirement that EAP be applied to tuition fees – in addition to tuition, funds withdrawn can be used to pay for books and living expenses to name a few.

Being withdrawals of tax-deferred income, EAP will be included in the taxable income of the beneficiary who receives the funds. With all taxpayers entitled to the basic personal exemption ($7,412 in 2001) and students eligible for the education credit ($400 per month), the tuition credit and student loan interest write-offs, there will be no income tax to pay on the EAP in the majority of cases. This means that, at the end of the day, the investment income earned inside the RESP could very well end up being completely free of income tax – a deal that’s hard to beat.

The fact that RESP investment income will most likely be tax-free is reason enough to give this method of financing post-secondary education the edge over other methods but there are other advantages that have put RESPs over the top – a topic that I’ll address next week.

Jim Maroney is a chartered accountant with Andrews Brown Maroney in Maple Ridge.