Strategizing withdrawals for the best outcome
Registered Education Savings Plans (RESPs) were originally introduced in 1972 and they were terrible. Seriously! We would regularly tell clients to avoid them, usually suggesting informal trust accounts instead as they provided much greater flexibility without the risk of losing all your gains. But in 1998 the introduction of a 20 percent matching grant made RESPs something to more seriously consider. Since then, regular tweaks (almost every other year) have made them an awesome vehicle that every parent and grandparent should consider. If there is a downside to these accounts, it’s that the rules around them are very complicated. However, the benefits so far outweigh the complications that we regularly extol their virtues.
What is not talked about much is how to best structure a withdrawal of the funds. The withdrawal rules are an order of magnitude more complicated than the deposit rules. A robust withdrawal strategy usually makes a huge difference to the net benefit of these accounts, since all the grant received as well as all the growth in the plan will be taxed in the student’s hands upon withdrawal. Unfortunately, we can only scratch the surface in an article like this. We strongly advise getting help.
Let’s look at a close-to-real-life example. Fred and Wilma have been setting aside money every month for their daughter, Pebbles, for 18 years and have set aside $36,000. On top of that, government grants added $7,200 and the plan has grown by $30,000. In total they have $73,200 in Pebbles’ account. They are now considering whether to start withdrawals.
Fred and Wilma expect Pebbles to go to school full-time for four years (which will likely span five calendar years). They don’t need to give her any money this year due to the scholarships she’s received and the money she’s earned from working. They expect she will make about $5,000 per year in earnings. Should they take money out of the RESP? And if so, how much?
In most cases I lean towards taking out all the non-taxable contributions plus just enough of the taxable grant/growth to bring the student to just under the $15,000 mark in taxable income. Doing so will keep the student in a no-tax bracket and reduce future taxable gains in the plan.
In our example, I would say yes – Fred and Wilma should take some money out. In fact, I’d suggest taking out all the capital (that’s the $36,000 they put in) plus one-quarter of the grant and growth (which would be $9,300). The $36,000 is all tax-free, but the grant/growth will be taxable to Pebbles. With the $5,000 from employment plus $9,300 from the RESP as an Educational Assistance Payment (EAP), her total income for the year should fall just under $15,000.
Fred and Wilma can set the funds aside to give to Pebbles in the future. And if they can put it in a tax-free account, all the better! They are also withdrawing an amount that will keep Pebbles in a no-tax bracket. At the same time, they are taking out funds that have restrictions on them on the off chance that Pebbles ends up quitting her post-secondary schooling.
Keep in mind, every situation is unique and needs to be looked at independently.
I’ve seen situations where parents say, “We don’t need to pull the funds out, so let’s just keep them there”. When they do eventually withdraw the money, the taxable amount is so large that 15 to 20 percent (or sometimes even more) of the grant and growth ends up going to taxes. That’s fine if there are no other options, but if we can pull it out tax free with a bit of planning why wouldn’t we do that instead?
If there is more than one child in a family, it’s common to name all the kids in a family RESP. This creates greater flexibility but also additional complication. Unfortunately, many RESP providers are great at selling RESPs. They’re just not so great at managing them or planning out a withdrawal schedule.
Before opening a plan, ask the advisor how they will plan withdrawals in order to get a handle on how equipped they are to do that planning. If you get a bad vibe, don’t sign up. Find someone you trust that can help you figure that out from start to finish.
It could easily be worth thousands of dollars to you or, more importantly, your child’s education.