Sending someone away from home to university for four years can cost more than $100,000. That’s taking into account tuition, books, transportation, room and board, and incidentals. Government cutbacks, inflation, and other factors could push those costs closer to $200,000 by the time your child is ready to go on to post-secondary education. Good tax planning will help you prepare for this major expense.
It makes perfect sense to start planning how to pay for your children’s post-secondary education as soon as possible—preferably when your child is born. If it’s too late for that, the best time is now.
To get a tax break for education costs, you have four options:
■ A Registered Education Savings Plan (or “RESP”).
■ An in-trust account.
■ A living (inter vivos) trust.
■ Juvenile life insurance.
From several standpoints, we think a mutual fund RESP is your best choice. They include investment strategy, costs, tax planning and legal matters.
Three types of RESPs to consider
There are three types of RESPs to consider when opening a plan. They are: an individual plan, a family plan, or a group plan. The first two types are similar. The main difference between them is that in the case of an individual plan there is only one beneficiary, whereas a family plan allows for more than one beneficiary. Group plans, on the other hand, work differently than both individual and family plans.
Group plans are sold by scholarship plan dealers and are often referred to as scholarship trusts. Scholarship trusts usually invest in lower-risk investments such as fixed-income securities—GICs, mortgage-backed securities and government bonds—and the pool is guaranteed. They pool the money you invest. The more money under administration, the more interest the pool makes. If your child or other beneficiary (which can include yourself) does not go on to post-secondary education, you get your principal back.
But the income earned during the time you’ve had your money invested may have to go back into the pool. Those beneficiaries who do go on can then use the income your money has earned.
With individual and family plans, on the other hand, you decide how the money is invested. You have complete flexibility. You can start out with 100 per cent of your money in growth funds—conservative or aggressive—it’s up to you. As the student gets close to university or college, you can shift into a balanced fund, then to money markets funds a year or two before he or she begins college or university. You make your own decisions.
When you can get some income back
As with scholarship trusts, of course, if your beneficiary does not go on to post-secondary education, you get your principal back. Plus, if the plan has existed at least for 10 years, and the beneficiary is 21 years old, you can get the income earned on contributions back, but you’ll have to pay tax on it, plus an additional 20-per-cent surtax. Or you may use the income, provided that it’s $50,000 or less, to fill up unused contribution room in your RRSP without incurring taxes.
The maximum lifetime contribution limit for a RESP is $50,000 per beneficiary. But there is no limit on how much can be contributed annually. Plus, the federal government will match your annual contribution with a basic grant of 20 per cent of the contribution, up to a maximum of $500, or $1,000 if there is unused grant room leftover from a previous year. There is a lifetime limit on these grants of $7,200. Additional grants are available for lower-income families. But keep in mind the grants will have to be repaid if the beneficiary does not matriculate to a qualifying post-secondary institution.
Fees vary according to the organization that administers the RESP. A discount broker, for example, may charge you about $100 annually to administer an RESP with a value of less than, say, $15,000. The fee is then waived on amounts in excess of this value.
A bank, however, may charge no fee to open an RESP as well as no annual administration fee. This option will appeal to you if you initially have modest sums to invest. Mutual funds would be the most likely investments for such a plan.
Group plans tend to be the most expensive. The Canadian Trust Scholarship Plan, for example, organizes its plans in units. There’s a sales charge of $200 a unit. According to the plan’s prospectus, it will take 32 months to pay off the sales charges. During this time, 34 per cent of your contributions will be invested in your plan. Plus, each year, 0.50 per cent of your net contributions, grants and income will be applied to an administration fee. Other transaction fees and fees for additional services also apply.
Despite the contribution limit on RESPs, we prefer it to an in-trust account, a living trust or juvenile life insurance. Unlike an in-trust account or living trust, an RESP provides a tax-deferral opportunity, and the money earned in the plan (but not contributed to the plan) is taxable in the hands of the beneficiary, who will presumably be taxed at a lower rate than you. A major drawback of the in-trust account and juvenile life insurance options is that there are no rules about how the beneficiary can use the money, meaning the child can use it for non-educational purposes, and you can do nothing about it.
Tax considerations differ from RRSPs
Your contributions to any type of RESP are not tax deductible. But the income in the plan is tax deferred. When the beneficiary withdraws it to use for his or her education, it becomes taxable in the hands of the beneficiary. If the beneficiary is a child with no other income, the rate of taxation is minimal.
Even if you can’t deduct contributions, and even if it’s not a large tax saving, it can serve to get you started on a disciplined savings program. That alone will prove invaluable to your child.
All post-secondary accredited institutions qualify—universities within and outside Canada; community colleges; CEGEPS, which are publicly funded pre-university colleges in Quebec; and junior and technical colleges in Canada. And you can change beneficiaries if your child, grandchild or other beneficiary decides to pass on post-secondary education. You could, for example, name a neighbour’s child, and, of course, make some informal arrangement to share the tax benefits. You can even name yourself, and do a little studying in retirement. The plan, after all, can exist for 35 years.
We suggest that you contribute monthly to the plan, instead of annually, to maximize the effect of compounding. If you contributed $230 each month for 18 years at 5.0 per cent average annual growth, by the time your child goes on to a post-secondary education, you’ll have, including principal, about $92,854. That may not pay for a full post-secondary program 18 years from now, but it will certainly be a good start.
And just think what an educational tool a RESP can be for children. They begin to learn at a very early age the importance and value of a long-term investment strategy, and about the power of compounding. It’s a life skill they may not be sufficiently exposed to in the classroom.
The TaxLetter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846