One case when paying more tax can mean more money

Under the right circumstances, RESPs and RDSPs can be excellent tax-deferred savings options. That’s particularly the case because the federal government will match contributions to these accounts based on a percentage of personal contributions.

There are times, however, where these two accounts may overlap: an RESP beneficiary could become disabled and be unable to pursue post-secondary education. In such cases, a parent may want to move the RESP savings over to an RDSP. While this may seem like a simple solution, there are nuances.

RESP refresher

The RESP allows Canadians to save up to $50,000 per beneficiary to pursue a post-secondary education. The federal government will match 20% ($500) of the first $2,500 of each year’s contributions, up to a lifetime maximum of $7,200 per beneficiary. For lower-income families, the government will add an additional 10% or 20% match, known as the Canada Education Savings Grant (CESG), to the first $500 of annual contributions (see “CESG thresholds”).

For years where contributions to an RESP are below $2,500, the missed grant can be caught up. The maximum annual CESG that will be paid for a beneficiary is $1,000 on a $5,000 contribution. The $1,000 CESG represents the current year’s CESG and one previous year’s missed CESG. Finally, the Canada Learning Bond (CLB) is available for low-income families and does not require contributions to receive it. The maximum CLB that can be paid per beneficiary is $2,000 ($500 in the first year and $100 per year of eligibility until age 15).

CESG thresholds

Source: CRA

RDSP refresher

The RDSP allows Canadians to save up to $200,000 for a beneficiary who is eligible for the Disability Tax Credit (DTC). Similar to the RESP, there are matching government grants and bonds.

The Canada Disability Savings Grant (CDSG) will pay $1,500 on the first $500 of contributions, and $2,000 on the next $1,000 of contributions, for families with income under $91,831 (2017). For families with income above $91,831, $1,000 of the grant will be paid on the first $1,000 of contributions. The annual maximum grant is $3,500. If grants have been missed from previous years, the maximum make-up amount is $10,500.

The Canada Disability Savings Bond (CDSB) does not require contributions, and up to $1,000 per year can be paid to eligible beneficiaries. The bond can also be caught up for missed years, to an $11,000 annual maximum. The lifetime maximum amount of grant and bond that can be paid to an RDSP is $70,000 and $20,000, respectively.

RESP-RDSP conundrum

Let’s illustrate a potential conundrum with an example.

Ron and Joyce Richardson have a 22-year-old daughter, Rachel, who was diagnosed with a severe mental disability when she was 3.

Ron and Joyce established an RESP for Rachel, but she was not able to pursue a post-secondary education. Since Rachel is eligible for the DTC, her parents opened an RDSP and make regular contributions. The RESP has a $14,000 balance consisting of:

• $10,000 in contributions,
• $2,000 in CESG and
• $2,000 in investment earnings.

The Richardsons want to close the RESP and move the money to Rachel’s RDSP. Since the RESP contributions were made with after-tax money, they can be withdrawn tax-free by the Richardsons and contributed in a lump sum to the RDSP. That sum would be eligible for the CDSG. The CESG in the RESP, however, must be repaid to the government since the RESP withdrawal is not for educational purposes. What can the Richardsons do with the $2,000 worth of investment earnings that remain in the RESP?

The options

Here are the Richardsons’ three options, all of which require the transfer to be considered an accumulated income payment (AIP):

• Transfer the $2,000 to one parent’s RRSP—assuming either parent has enough contribution room. This option would result in no immediate tax.
• Transfer the amount to Rachel’s RDSP.
• Withdraw the $2,000 and pay tax at their marginal tax rate plus an additional 20% tax.

In order for Ron’s transfer to be considered an AIP, one of three conditions must apply:

• Rachel’s RESP account has been in existence for at least 10 years, she is at least 21 and is not pursuing post-secondary education;
• her RESP has been in existence for more than 35 years; or
• she has a severe and prolonged mental impairment that would reasonably be expected to prevent her from pursuing post-secondary education (only applies to the RDSP transfer).

In this case, Rachel meets two criteria, so the investment earnings can be withdrawn as an AIP. Which option would result in a higher after-tax amount? If the Richardsons decide to transfer the AIP directly to one of their RRSPs or to Rachel’s RDSP, they would pay no tax on the amount transferred and would continue to have $2,000 invested. The money would simply switch accounts from the RESP to either an RRSP or Rachel’s RDSP. In addition, the transfer to the RDSP would reduce Rachel’s lifetime contribution limit by $2,000 and would not be eligible for CDSG.

Alternatively, what if the Richardsons withdraw the funds, pay all taxes and contribute the remaining amount to Rachel’s RDSP? While the dollar value of the contribution would be less than $2,000, it would be eligible for CDSG. Will the value of the CDSG be greater than the tax payable and result in more than $2,000 of additional funds in Rachel’s RDSP? Let’s find out.

How the numbers work

Let’s assume Ron is in a 40% tax bracket when he takes the $2,000 AIP:

Incredibly, under Option 3, Rachel would have $900 more in her RDSP, even with her father paying 60% tax up front on the AIP compared to the other two options. In addition, the rollover from the RESP directly to the RDSP (Option 2) would result in a $2,000 lifetime contribution reduction, while Option 3 would result in a $800 lifetime contribution reduction that would also be CDSG-eligible. This additional $1,200 of contribution room could lead to additional future CDSG of $2,900 ([$500 x 300%] + [$700 x 200%]).

In the best-case scenario, if Rachel had carry-forward CDSG from previous years, she could have received $2,400 in total CDSG on an $800 contribution for a total RDSP increase of $3,200. In the worst-case scenario, if Rachel’s income was above $91,831, she would have only received $800 in grant money for a total RDSP increase of $1,600. In the latter scenario, Ron and Joyce would be better off transferring the AIP directly to the RDSP, avoiding the upfront tax.

Finally, if Ron were already planning to contribute to his RRSP, he could consider reducing those contributions by $2,000 and transferring the AIP to his RRSP—thereby avoiding the 20% penalty tax (as in Option 1).

As a result, he would have an extra $2,000 of his own cash that he could contribute to Rachel’s RDSP. Since the RDSP contribution is not part of the AIP transfer, it would be fully eligible for CDSG, leading to the maximum grant of $3,500 ([$500 × 300%] + [$1,000 × 200%] = $3,500).

Conclusion

While it may seem counterintuitive, paying tax may lead to more money in your client’s pocket when moving investment earnings from an RESP to an RDSP for the same beneficiary. The benefit of the RDSP grant can offset not only the subscriber’s marginal tax rate, but also the government’s imposed 20% additional tax penalty. Before rolling over an RESP AIP to an RDSP, run the numbers to see which option provides the largest asset balance for your client.

Curtis Davis

Tax & Estate

Curtis Davis, FCSI, CFP, TEP, is director for tax, retirement and estate planning services, retail markets at Manulife Investment Management.