It is one thing for families to plan for their financial futures but executing the plan is also vital. It is one thing to save. It is another to use those savings effectively. This is never more evident than in the case of registered education savings plans or RESPs.
To illustrate, I’ll use the example of my eldest nephew, Michael. He’s heading off to university this fall and from the first moment of frosh week, he will benefit from his parents’ savings efforts.
Like many parents nowadays, they simply assumed that Michael would have a post-secondary education, although they didn’t actually start saving for it until 1998. That was the year the federal government introduced the Canada Education Savings Grant or CESG, which added a minimum government payment of 20% of the RESP contributions that parents had made until the calendar yearend in which a child/beneficiary turned 17.
Despite their delayed start, Michael’s parents saved enough in his RESP over the past 13 years to maximize the government’s contribution through the CESG. Michael’s RESP balance is now enough to pay for a substantial portion of his university education.
Michael’s parents have succeeded in completing part one of an important financial planning equation. Their focus on saving, especially through an RESP that confers government grants as well as a tax deferment until withdrawals are made, is a worthy achievement. But as I noted, from here on, execution, which in this case refers to managing the drawdown of those savings, is key. The purpose of this article is to simplify the RESP withdrawal process so your clients will be able to make the most effective use of savings for education. Many investors find RESP rules complex – just visit the government of Canada’s or the Canada Revenue Agency’s websites to sample the intricacies – so anything you can do as an advisor to simplify the withdrawal process will add considerable value to your client relationships.
One plan, two types of assets
The account balance in any RESP consists of two types of assets. One is contributions, the amount contributed to the plan by its subscribers. The second is accumulated income, a basket that includes CESG grants, capital gains on plan investments, interest and dividends. The important distinction for your clients to know is that the withdrawal of contributions, referred to as post-secondary education payments or PSEs, will not be taxed (which makes sense because there wasn’t a deduction on the initial contribution). However, the withdrawal of accumulated income, termed an education assistance payment or EAP, will be taxed as ordinary income in the hands of the student.
In most cases, it’s preferable that EAP withdrawals be taxed in the hands of students like Michael since they’ll normally be in lower tax brackets than their parents, the plan subscribers. As well, students will have their own personal exemptions as well as tuition, education and textbook tax credits. You might also want to point out to clients that if students don’t use up their tuition, education and textbook credits in the current year, they can be carried forward to a future year. Likewise, these credits – up to a maximum of $5,000 – can be transferred to the parents or the student’s grandparents.
The rules of withdrawal
To make a withdrawal from a RESP, the subscriber rather than the beneficiary – Michael’s parents as opposed to Michael – must initiate the process, advising the financial institution that holds the plan what type of withdrawal they desire, whether it’s a capital or an EAP. Michael’s parents will need to provide proof that Michael is attending a qualified post-secondary educational facility on a full- or part-time basis. The list of post-secondary schools that qualify is quite generous, and includes Canadian universities as well as community, junior, vocational and technical colleges. Numerous universities outside Canada may also qualify so long as a student is enrolled in a course lasting a minimum of 13 consecutive weeks.
In those first 13 consecutive weeks of Michael’s post-secondary education, his parents can only withdraw $5,000 of accumulated income as an EAP. After that, they can withdraw as much of the RESP’s accumulated income as they wish – as long as Michael continues to attend school.
Circumstances alter withdrawal needs
Other considerations can determine how much Michael’s parents may wish to withdraw as EAPs. For instance, Michael had a part-time job in his last half year of high school and he had a summer job. Still, he doesn’t plan on working part time while he’s attending classes at university. In other words, Michael won’t have much employment income this year, so it will make sense for you to advise his parents to withdraw the maximum $5,000 EAP in those first 13 weeks of university.
After second year, Michael may apply to a co-op program. If he has two work terms in one calendar year, you might want to advise his parents to limit EAP withdrawals, since he will undoubtedly be in a higher tax bracket than he would have been had he been at school for two terms and held a summer job. He would also have less tuition and education credits because he spent less time at school.
If Michael decides to go on to a second degree, he may want to delay withdrawals. A RESP can stay open for 35 years after the year in which the account was created, providing more than ample time to decide on and complete a postgraduate degree. Of course, Michael might want to run down the account while completing his undergraduate degree. After all, the future is uncertain and, while he’s a student, Michael’s tax rate is going to remain relatively low.
Realistically, because Michael’s parents didn’t set up the RESP until 1998, he will likely exhaust it by the time he gets his undergraduate degree. But on the off chance there is some money left in the account when he finishes, it’s worth remembering the flexibility the government has built into the RESP rules. After Michael finishes a qualifying program, there’s a six-month grace period in which he can still receive an EAP, provided that he would have qualified had he still been enrolled.
Collapsing a RESP
And in theory, there’s no rush for Michael’s parents to collapse the RESP once he’s completed his undergraduate degree. As I mentioned, the account can remain open for 35 years from the year it was first established. But if his parents decide to collapse the plan, they should be aware of the tax implications. Once the plan is collapsed, the unused CESG will be returned to the government while the capital contributions are returned tax free to the subscriber. The accumulated income, the amount remaining in the account, will then be included to the subscriber’s gross income for tax purposes. In addition, the remaining accumulated income will be charged a tax of an additional 20%.
There is a potential way around this penalty. If Michael’s parents, the plan’s subscribers, have unused RRSP contribution room, the can transfer up to $50,000 to their RRSPs, thus deferring the tax and avoiding the penalty. If Michael had any siblings, there would be another solution. In that case, the RESP account could be transferred penalty-free to a brother or sister. Again, the 35-year rule would still apply. Failing this, the RESP can be collapsed, leaving the subscribers to deal with the penalties that apply to the non-contribution portion of the account.
Starting post-secondary schooling is an exciting and stressful time. This is true not only for students, but also for parents. It’s extremely important that families be financially prepared for the costs of higher education. And inevitably, post-secondary education will become more rather than less expensive. From your perspective as an advisor, it’s also critical that clients have a sound understanding of the RESP rules so that they can ensure their children’s educations without facing hardships and unnecessary tax penalties. By giving them a clear picture, you’ll help them and strengthen your relationship.
Michelle Munro is director, tax planning, for Fidelity Investments Canada ULC.