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Two-pronged strategy best for saving for a child’s education

by Wayne Cheveldayoff, 2003-11-24

As the end of the year approaches, financial planners are urging parents to make sure they set up a Registered Educations Savings Plan (RESP) if they don’t already have one and get the contribution in by the December 31 deadline.

While RESPs are a good vehicle to save for a child’s post-secondary education, a two-pronged strategy that includes the use of an in-trust account is even better.

Both have benefits that can help offset the disadvantages of the other. The dual strategy wisely takes into account the tax benefits of in-trust accounts as well as the possibility that the child may not go to college or university.

The RESP is favoured by financial planners in their advertising because it can yield a cash grant each year from the federal government and it is easier to get people to focus and respond when free money is involved.

The RESP grant, known as the Canadian Educational Savings Grant (CESG), is 20 per cent of a contribution up to $2,000, which amounts to $400 per calendar year. The maximum lifetime grant limit is $7,200 per child.

Over an 18-year period, contributions of $36,000, plus $7,200 CESG, plus investment earnings add up to a nice educational nest egg for the child, paying for maybe a couple of years of college or university for those living away from home.

From the tax point of view, investment earnings on both contributions and the grant accumulate tax free inside the RESP. When it comes time to pay for post-secondary education, the contributions are withdrawn tax-free by the parents, and the grant portion and investment earnings are paid out to, and treated as income in the hands of, the child.

This RESP payout to the child should effectively either avoid income tax or be subject to the lowest rate, since it comes at a time when the child is expected to have low income and lots of educational deductions.

The RESP rules actually allow $4,000 to be contributed per child each year. But it makes a lot of sense for contributions over $2,000 to be allocated to an in-trust account for the child. That way, if you have, say, a total of $4,000 to invest per child each year, you can get the maximum government grant with the first $2,000 and then the advantages of a in-trust account with the other $2,000.

In-trust accounts are usually available through full-service or discount brokerage houses. They essentially involve a parent (or grandparent) setting up an account in the name of the child in trust. All money put in the account immediately becomes the property of the child, but it is held in trust and managed by the contributor until the child is 18, at which time the child takes complete control.

Parents remembering how they were at 18 may be put off by the prospect of their children getting their hands on a large sum of cash that they can do anything they want with. But this can be handled with a good amount of encouragement about the importance of getting higher education.

Also, the parent does not lose complete control, as the parent retains authority over the disbursement of the RESP funds.

But while the parent gives up some control, there is a corresponding gain in tax saving and flexibility with in-trust accounts, which is what makes them attractive.

While any interest or dividends earned in an in-trust account are taxed in the hands of the parent, the capital gains are taxed in the hands of the child.

Every few years as the child is growing up, the investments can be sold and others purchased to trigger the capital gains, which are reported in the child’s tax return, taking full advantage of the ability of each taxpayer to have in excess of $7,000 income each year without paying tax.

To work best, for those following a balance portfolio approach, it makes the most sense to have interest and dividend-producing investments in the tax-shelter of the RESP, reserving the in-trust account for investments that yield capital gains.

Using this in-trust strategy, when the child gets to 18, he or she should have a healthy tax-free sum available. If it is used for education, it won’t be, in contrast to the RESP payouts, treated as taxable income.

Depending on the child’s income, this could well amount to a substantial tax saving. Also, if the child doesn’t go to college or university, the in-trust account can be used for any purpose at the child’s choosing.

With sums accumulated in an RESP, however, if the child doesn’t go to college or university by the age of 25, the plan is collapsed with the tax-deferral largely lost and nothing going to the child. The contributions go back to the parent, the grant portion goes back to the government, and the investment earnings are taxed at a special,higher-than-normal, onerous rate in the hands of the parent (although there is a provision for transferring this portion to an RRSP is there is contribution room).

As two heads are often better than one in figuring out a problem, a two-pronged strategy on educational saving has advantages that parents shouldn’t ignore.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. He can be contacted at

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©2003 Wayne Cheveldayoff