From the cradle to graduation, there are some good opportunities to split investment income with your child.
Taking these opportunities will allow you to save income tax and therefore build wealth faster.
You can start with the very first installment of the child tax credit. Canadian tax rules allow you to deposit this credit in a bank account for your child, with the interest earned on the account treated as the child’s income instead of yours.
This interest income then is reported on a tax return for your child. As long as the child’s income is lower than the basic deduction of around $8,000, the interest will be tax-free.
Of course, to file a tax return, the child will need a social insurance number (SIN), so you need to apply for one and let the bank know what it is so that its reporting of the interest will be under this number.
The SIN number will also be needed to take advantage of the Registered Educational Savings Plan (RESP), which is an opportunity to not only split investment income but also get a government grant for your child.
You can put $4,000 a year for 10 years into an RESP. The sum invested within an RESP is sheltered from income tax until it is used to pay for post-secondary education (or the plan is collapsed if the child doesn’t attend post-secondary education).
For the first $2,000 you put into an RESP each year, the government deposits an additional 20 per cent, up to $400. The $2,400 then can earn interest, dividends or capital gains tax-free.
When it comes time to pay for college or university education, all of the parent’s contributions over the years can be withdrawn on a tax-free basis. The remainder, made up of investment income and government grants, is paid out to the child and must be declared as income in the year received.
With the significant deductions available to the child from tuition and education credits, along with the basic personal deduction, it is likely that little, if any, of this income would be subject to income tax.
Another strategy to split investment income involves the use of an in-trust account for the child. In effect, the parent gifts money to the child and the money is invested in a special account managed by the parent but held in trust for the child. Income from the in-trust investments is attributed back to the parent, but capital gains are taxed in the child’s hands.
The exemption of capital gains from the attribution rules opens up a significant opportunity to save on income tax by investing the in-trust sums in capital-gain-oriented investments.
An obvious choice would be growth stocks, but it would also work for income trusts whose cash distributions are regarded as the return of capital. Such return of capital lowers the adjusted cost base and when the investment is sold, the difference between the sale price and adjusted cost base is treated as a capital gain.
The investments can be sold every few years to trigger capital gains at times when the child doesn’t have much other income.
Using these strategies to save tax, there is no need to abandon the principle of a balanced portfolio.
The in-trust account can be loaded with growth stocks and growth-oriented mutual funds, while the RESP can contain GICs, bonds and income trusts whose cash distributions are normally regarded as taxable income.
One thing for the parent to keep in mind is that the funds in an in-trust account belong to the child. When the child turns 18, he or she can claim it all and do what they want with it. In contrast, the parent retains control of the funds in an RESP and can dispense them to the child up to age 25 as appropriate as long as the child attends a post-secondary institution.
While the parent loses some control when the child turns 18 with an in-trust account, the benefits are potentially infinite since, in contrast to the RESP, there is no limit on what can be set aside for the child in such an account.
These tax-saving tactics apply to everyone. However, parents who are entrepreneurs and own companies may have other options, such as making children shareholders of the business. Anyone contemplating those types of strategies needs to consult a tax specialist and consider issues of control and ultimate sale of the business.
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. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.
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©2004 Wayne Cheveldayoff