RESPs, RRSPs and Financing Higher Education

Entrepreneurs/Family Businesses

RRSPs, Loans & Grants

RESPs

General Rules

Through successive budget changes over the years, the government has tried to create a successful incentive for people to put aside money for their children’s education. It was only when the government decided to match contributions at 20% to a maximum of $400 per year per child for eighteen years that the RESP program took flight. While the pragmatic issue for many may be “Where will I find the money?”, the government’s initiative has turned a relatively simple matter into rocket science proportions. While the best strategy varies with individual circumstance, after reviewing the literature, we recommend the following:

  • Apply for a SIN now (it takes 6-8 weeks)
  • Establish an RESP as soon as possible. Contribute $2000 per child from family sources.
  • Apply for the matching grant of 20%
  • If you receive child tax benefits which you do not need for daily living expenses, establish an In Trust Account for these monthly proceeds
  • Use the child’s SIN for the trust account, too
  • If you can afford more, have the non-trustee family member contribute to the In Trust account
  • Decide on your investment strategy, given the child’s age and your risk attitudes
  • If your investment strategy includes a balanced portfolio, invest in capital appreciation with your contributions to the In Trust account and invest in interest-bearing securities in the RESP and with the child tax benefit proceeds in the In Trust account.
  • Remember that neither the RESP nor the In Trust account have foreign content restrictions like an RRSP/RRIF, so spread your growth around the globe.
  • Watch your investment strategy mix as the child approaches withdrawal requirements

In Trust Accounts

Advantages
  • Contribute as much as you like/can afford
  • Children do not have to pursue higher education. they can use for any purpose, including living expenses or traveling or buying a home
  • Brokerage accounts carry no admin fee
  • No annual contribution deadlines
  • Preferential capital gains tax treatment is retained
Disadvantages
  • Tax attribution arises unless investment strategy is directed solely to capital appreciation until the child attains age 18
  • No matching contribution from the government
  • Funds will go to the children even if they turn out to be troublesome
  • The contributor should not be the trustee
  • There may be year-to-year tax matters

RESPs

Advantages
  • Government will match at 20% to $400 per year for 18 years
  • Investment strategy can incorporate either capital appreciation or more conservative GICs etc
  • Anyone can contribute
  • No taxation matters until withdrawn
  • Can change beneficiary to blood or adopted relation
Disadvantages
  • Student must pursue higher education for full advantage of income splitting
  • Limited to $4,000 per year to a lifetime maximum of $42,000, plus the government’s contribution (maximum $7,200)
  • Covers tuition etc only
  • All investment income is characterized as regular income upon withdrawal; therefore, preferential capital gains treatment is foregone
  • Brokerage accounts may carry admin fees
  • Recipient must be a Canadian resident
  • Requires child to have a SIN number
  • Annual contribution deadline is Dec 31st

19 Things to Know About RESPs

  1. The child (beneficiary) must have a social insurance number
  2. The annual contribution limit per child is $4,000
  3. The lifetime contribution limit per child is $42,000
  4. The government matching grant is 20% of your contribution to a maximum of $400 per year per child (e.g. a $2,000 contribution by you), to a lifetime maximum of $7,200
  5. Unused grant room can be carried forward for one year, therefore the maximum grant in any one year is $800
  6. One plan can have multiple designated beneficiaries and a couple can be joint contributors of the plan
  7. An individual child can be the beneficiary of multiple plans (e.g. set up by a parent and a grandparent) but the limits apply to the child, not to each plan
  8. The subscriber can be the beneficiary
  9. There must be a contribution to the plan before the year in which the beneficiary turns 16
  10. There is a limit of 21 years for contributions to the plan and the plan must be collapsed by the end of 25 years
  11. The contributions are not tax deductible to the contributor; however, the income is not taxable to the contributor year-to-year either
  12. There is no restriction on the type of investment or the amount of foreign content allowed
  13. The beneficiary must attend a qualifying educational program at a designated institution to receive funds from the plan
  14. If one of the beneficiaries of the plan does not qualify for the educational assistance, the funds can be paid to other beneficiaries
  15. If all the beneficiaries reach the age of 21 without qualifying and the plan has been in place for at least 10 years, the income can be repaid to the contributor, who must either contribute it to his/her own (or spouse’s) RRSP or else pay a tax penalty of 20% of the income amount in addition to the regular income tax on that amount. The RRSP contribution is limited to $50,000 per sponsor (i.e. $100,000 for a couple who sponsors a plan jointly) and such person must have that amount of RRSP contribution room available. Note that it might not be wise to have grandparents as contributors because they may be beyond the age of allowed RRSP contributions (age 69)
  16. If there are no qualifying beneficiaries, the grants must be repaid
  17. The principal amount can be returned tax-free to the contributor whether or not there are qualifying beneficiaries
  18. The contributor can decide whether or not the principal is paid out to the beneficiary in addition to the income
  19. The income from the plan is paid out and taxable to the beneficiary when received

Enhanced Canada Education Savings Grant (CESG) payments

The 2004 Budget proposes an enhanced matching of CESG for the first $500 per year of contributions made to RESPs by low- and middle-income families as follows:

  • 40% CESG matching rate for low-income families ($35,000 and less)
  • 30% CESG matching rate for middle-income families ($35,000 to $70,000 – subject to indexing)

All other eligible contributions continue to qualify for the 20% CESG matching rate (so families with income over $70,000 and/or annual contributions over $500). The enhanced rate is effective January 1, 2005, however, the first enhanced payment may not occur right away to allow for administrative systems to get in place.

Qualifying family net income is the same basis as that used for the National Child Benefit (NCB). Enhanced matching rates will apply to a maximum of $500 per year for a child in any given year. There are no carryforward provisions available. If there are several RESPs of which the child is a beneficiary, the $500 limit for enhanced rate will apply jointly to all RESPs. Where the subscriber is not the primary caregiver of the child, consent is required by the primary caregiver for the enhanced CESG rate to be paid. Otherwise, only a 20% CESG matching rate will apply.

To prevent subscribers from withdrawing and re-contributing to get the higher rate, for any withdrawals after March 22, 2004 for non-educational purposes, subsequent contributions will only get the 20% CESG matching until the RESP returns to the previous level.

Getting the Money Out

While “RESPs” have been around for a long time, it was the government announcement in 1998 that they would create a system of matching grants that propelled this savings vehicle onto everybody’s agenda. The government’s matching system contributes up to $400 per year per child and everybody has figured out that this amounts to a “20% return” on your money before you even invest it.

Unfortunately, this relatively-minor part of the world’s entire functioning almost merits full time study to understand all of the fine points of the law related to it. Now that we are all a few years older, we are beginning to receive phone calls from clients who are ready to withdraw money to fund their children’s post-secondary pursuits. So, this article will focus on another myriad set of rules related to that.

The normal purpose of the whole process is to fund post secondary education of a child who is a designated beneficiary of the plan. A secondary purpose of this is income splitting whereby the investment income earned over the years is not taxed annually to the contributor, but only upon withdrawal to the beneficiary. If the student has little or no other income plus the usual sort of deductions and credits available to a student, it is likely the sum withdrawn will bear little or no tax. The third purpose is to receive the grant money.

The money that builds up in an RESP over the years comes from three sources; contribution of capital by the subscriber, the government matching grants and the investment income earned from both. The table shows the amount that can accumulate over an entire lifetime for one child, assuming maximum contributions and grants and an 8% return thereon (in fact, the plan would continue to earn more income through the schooling years, too).

 Contributions

 $42,000

 Grant

 7,200

 Income on contributions

 67,000

 Income on grant

 9,000

 Total

 $125,200

All money coming out of an RESP must be one of four types: educational assistance payments (“EAP”), repayment of capital, accumulated income payments (“AIP”) or payment to a designated educational institution. This article will address the first two of these.

The pot of EAP money includes the government matching money and all of the investment income earned. In order to receive “EAP”, the student must be enrolled in full-time studies (full time study within Canada requires at least ten hours per week for a minimum of three weeks; part-time study does not qualify unless the student has a certified mental or physical impairment) in a qualifying post-secondary educational institution (this includes all colleges and universities as well as other institutions certified by the government. Note that this also includes foreign institutions, with the additional requirement that the program is at least thirteen continuous weeks).

There is no limit on the EAP amount withdrawn to a qualifying beneficiary, except for RESPs created after 1998, where the maximum amount withdrawable is restricted to $5,000 until the completion of thirteen consecutive weeks (i.e. typically a “semester”). There is no limit after this unless the student withdraws from school for a twelve month period and returns later, in which case the “$5,000 rule” applies again. The $5,000 maximum can be over-ruled by the government upon written request if, for instance, the educational costs are high (e.g. expensive tuition in a graduate program or foreign school).

The student may be earning part-time income whilst receiving EAP, except when the employment is directly connected to the program of study (e.g. work periods in a “coop” program).

EAPs are intended to “further studies” of the student. Thus, the money can be used towards any aspect of that, including tuition, books, travel to school, accommodation and general living costs. The “promoter” (i.e. financial institution holding the funds) is supposed to determine the reasonableness of the expenses. However, in fact, no receipts are required to be submitted to the institution. The promoter is only required to obtain proof that the beneficiary qualifies (i.e. conditions as explained above). We reviewed the EAP application form of one financial institution and ascertained that it was left to the contributor to make a signed representation that the expenditures were within the spirit of the law.

This would appear to provide a degree of license in the absence of tighter government rules. For instance, for accommodation, would furnishing the student apartment at Ikea qualify? Or more aggressively, how about purchasing an apartment? For transportation, plane fare to-and-from home at Christmas and the start and end of the school year should qualify, as well as bus passes to school.

All qualifying EAPs are taxable to the student and evidenced by a T4A slip. This income does not create additional RRSP contribution room for the student. Note that one negative tax implication of the RESP system is that all capital gains investment income earned will be classified as fully-taxable income, ergo not enjoying the tax-free one-half exclusion in the regular tax system.

The second type of withdrawal is repayment of capital. This is the money contributed by the subscriber over the years. The maximum that this could be is $42,000 times the number of children if this is a “family” plan. When a withdrawal request is made, an election can be made to withdraw some or all of this capital. You also may choose either to return the money to the original contributor or to the student. This is tax-free to either party. This is an important difference underlying the whole idea. If the student is to receive the capital, then implicitly it is the contributor’s intention to gift this money. If the contributor is to receive the capital back, then implicitly, it was his/her intention effectively to provide an interest-free loan to the student where the capital is deployed over the years to earn investment income to fund the education. This means that the contributor could request, for instance, return of ALL of the capital from the RESP, leaving only the accumulated income and grants for the student.

There is one catch. If capital is withdrawn while no beneficiary is enrolled in a post-secondary educational institution, then the government grant must be repaid at the rate of 20% of the amount withdrawn.

The contributor may designate anyone to receive the capital of the RESP upon death, e.g. the children, the surviving spouse or the estate itself (which then will be governed by the will).

An RESP must be terminated by the end of the twenty-fifth year after the year in which it was created. At that point, all of the taxable dollars need to have been paid out to qualifying students as EAPs or else any remainder will become an AIP taxable to the contributor. This would appear to require some attention to planning if you have a family RESP with children of disparate ages. The twenty five years would tick down from the first child, requiring dissolution of that plan when the youngest child indeed may be many years from university, even though that plan includes contributions, grants and earnings for the younger child. Strategically, it may be wise to “spend” the EAP money as quickly as you can, to ensure using it up, and deal with saving for the younger child in a new RESP or through other means.

An on-going issue over the years has been the risk associated with having designated beneficiaries who in fact will qualify for RESP withdrawals, i.e. carry on with significant post-secondary education. This risk is mitigated to the extent that a family plan exists and includes several beneficiaries, only one of whom needs to qualify in order for the funds to draw out. However, “equity” issues may still exist in the mind of the contributor. For instance, if only one of two children goes on to higher education, does that student “win all the marbles”? Certainly, all of the investment income and grant money would need to go to that child if the intended tax advantages are to be had. However, the “unsuccessful” child could receive the repayment of capital, either directly or indirectly, in order to balance out the gifting. The previous table of a hypothetical plan shows that it may not be possible to achieve balancing – the successful student would need to receive $166,400 ($83,200 times two children), leaving only $84,000 for the unsuccessful child. This confounds balancing and it may be hard to spend $166,400 on one education.

Canada Learning Bond (CLB)

For each child born after January 1, 2004, he or she will be eligible for a CLB in each year to the age of 15 that the child’s family is entitled to the National Child Benefit (NCB) supplement. The CLB is provided as follows:

  • $500 for the first year of entitlement of the NCB supplement in any year from birth to age 15. So, if the parents are entitled to NCB in the year of birth, the child is entitled to $500 at birth. A SIN number must be available for the child.
  • $100 for each subsequent year, provided the family is still entitled to NCB. So, when a child turns 1 in the year and the family entitled to NCB, the child will be entitled to $100 that year.

As a result, entitlements can be up to $2000 over a child’s lifetime to age 15.

A CLB must be transferred to an RESP for a child to have access to the bond and for it to begin to earn income. If the bond is not transferred by the child’s 18th birthday, the child will have up to three years to open an RESP. If the bond has not been transferred by age 21, it is forfeited. The Government will provide an additional $25 upon opening the RESP to initiate the transfer of the first $500 to cover administrative costs.

Only the primary caregiver for the child (the person receiving the NCB) can authorize the transfer of the CLB into an RESP, although anyone can subscribe to an RESP for the benefit of that child.

The Department of Human Resources and Skills Development will track the annual entitlements. Even though this is effective January 1, 2004, the first payment will likely not occur until after January 2005 to allow for administrative systems to be put in place. Children for whom a Children’s Special Allowance is paid will also be eligible for the CLB.

The CLB amounts will not be taken into account in calculating annual and lifetime RESP or CESG contribution limits. CESG matching amounts will not be paid on CLB amounts transferred into an RESP. A specific portion of each Education Assistance Payment will be considered to be attributable to the CLB, the CESG and investment income, and fully subject to tax. Unlike CESG, CLB entitlements cannot be shared with other beneficiaries in a family or group plan.

Children of Entrepreneurs

Children of entrepreneurs may help finance their higher education by working for the family business and drawing a salary. However, such compensation must answer to reasonableness in items of hours worked and skill set available.

In the alternative, children could draw money from the family business as an “appropriation” uder section 15(2). This amount is included in the student’s income that year. Depending upon the amounts of the other income and of student deductions, the 15(2) amount may be tax -free. It is important to note, however, that the corporation would not get a tax deduction for this sort of payment, which it would for salary payments. On the other hand, a 15(2) advance is not subject to ‘reasonableness’.

What makes this work better is that the student can repay the loan any time in the future (e.g. when graduated and in the work force) and claim an offsetting deduction that year under section 20(l)(j). The receipt is not taxable to the corporation.

The value of the tax deduction to the employed graduate likely would exceed the cost to the 15(2) income inclusion while a student.

Updated: Nov/09