Are You Getting a Passing Grade on Education Savings?
The cost of a post-secondary education in Canada is high, and it isn’t going to get any better. So how do you make sure you go to the front of the class when it comes to saving for your child’s education? The answer—make sure you take advantage of all the tax breaks, including income splitting.
When saving for your child’s education, there are two main strategies to consider—a Registered Education Savings Plan or RESP and what is generally referred to as an “in-trust” investment account.
RESPs have been around for a long time, and remain a powerful tool. Under an RESP, funds are invested in a tax deferred plan and the investment income is eventually paid out as taxable income to your child when he or she goes to college or university.
An in-trust account takes advantage of an exception to income attribution tax rules. Under these rules, if you gift money to your minor child in trust or loan money to a trust for the child, any income earned will be treated as your income. But, there’s an exception—these rules don’t apply to capital gains. So, if you pick investments that will produce capital gains, such as equity investments, then your child will be taxed on the income. With a 50% inclusion rate on gains and a personal credit available, often no tax arises.
For 2007, there are three important RESP changes to consider:
- The annual RESP contribution qualifying for the Canada Education Savings Grant (or CESG) was increased to $2,500 from $2,000,
- The annual RESP contribution limit of $4,000 was eliminated, and
- The lifetime RESP contribution limit was increased to $50,000.
These changes mean you have some homework to do—should you concentrate on making RESP contributions since the annual limit was removed or should you put just enough money into an RESP each year to get the CESG and put the rest into an in-trust account?
To see what gets a passing grade, let’s work through the numbers with Mary and her newborn daughter Emily. With her husband, Mary thinks she’ll be able to put away $3,000 a year for Emily’s education (over 18 years). Also, Mary’s mother wants to contribute another $10,000 now towards Emily’s education.
As discussed, Mary has two choices—she can put all of her education savings into an RESP as it becomes available and then use an in-trust account (or a formal trust) later once the $50,000 limit has been reached. Or, she can just put enough money in an RESP each year to get the maximum CESG, and put the rest into an in-trust account.
The chart below shows what will be available after contributions over 18 years under each option:
Maximizing the RESP looks like the best choice. However, you’ll get an A+ if you remember that an in-trust account represents after-tax money while the accumulated income and CESGs in an RESP is taxable when withdrawn. Therefore, if Mary chooses to maximize RESP contributions, there will be about $31,000 more in accumulated income in the RESP when Emily goes to college or university. Although Emily may be able to avoid tax on this extra income with her combined tuition, education and textbook credits, remember that unused credits can also be transferred to Mary or her husband (within limits) or carried forward to the taxation year when Emily begins to work full time. Preserving $31,000 of education-related credits is currently worth around $7,500 (depending on where you live). An added benefit is that you have $31,000 more that is not restricted by RESP rules in terms of how the plan income can be paid out (if Emily doesn’t go to college or university).
Many advisors are suggesting that you take full advantage of the elimination of the annual RESP contribution limit, but you’ll be on the honour roll if you remember you have other options.
If you are saving for your child’s education and have further questions, contact your BDO advisor to discuss.
Next Section: Update on Withholding Taxes on Cross-Border Interest Payments
