As advisors, many of us are well versed in educating our clients about the benefits of saving for their children’s (or in some cases their grandchildren’s) post-secondary education via the RESP. Given the bull market of the past decade, some RESPs have grown to some serious dollars, but have you devoted enough time to explaining to your clients how they should be withdrawing those funds in a tax-effective manner?
Before delving into a strategy, let’s review the main types of RESP withdrawals and how they are taxed.
When funds are withdrawn from the RESP, they can take one of these forms: refund of contributions, educational assistance payments and accumulated income payments.
Refunds of contributions
When considering RESP withdrawals to fund post-secondary education, the first thing to remember is that contributions made to an RESP, which were not tax-deductible, can generally be withdrawn at any time, tax-free. These are referred to as refunds of contributions (ROCs).
Educational assistance payments
Any other funds coming out of the plan for post-secondary education are referred to as educational assistance payments or EAPs. This includes the income, gains and Canada Education Savings Grants (CESGs) in the RESP. When these are paid out, they are taxable to the student.
Accumulated income payments
If all the beneficiaries under the RESP either decide not to pursue post-secondary education or have completed their post-secondary education, and there are still funds left in the RESP beyond the original contributions, a Canadian-resident RESP subscriber may be entitled to receive the accumulated income and growth as an accumulated income payment (AIP). (Any remaining CESGs would have to be repaid.)
To qualify, an AIP can only be made after the ninth calendar year following the year the RESP was opened and only if all beneficiaries of the RESP have reached the age of 21 and are no longer eligible to receive EAPs.
The problem with AIPs is that they are subject to potentially heavy taxation. First, the AIPs are taxed as ordinary income at the subscriber’s marginal tax rate. But to compensate the government for the fact that no tax has been levied on the income/growth in the RESP for up to 35 years, the government charges an additional 20% penalty tax on top of the regular tax rate. For a high-income Ontario (grand)parent, this could translate into an effective tax rate of 73.53% on any AIPs. If, however, the subscriber has unused RRSP contribution room, they may be able to roll over up to $50,000 of AIPs into their RRSP and avoid the 20% penalty tax.
How best to withdraw funds in 2021?
This brings us to the question of how, with a large RESP, clients should be directing withdrawals to minimize any income/growth from being left over at the end of the kids’ post-secondary studies and potentially being subject to an effective tax rate of up to 73%.
Intuitively, it might seem attractive to withdraw only ROCs, since they are simply non-taxable. But if the goal is to minimize the family’s taxes over the kids’ course of studies, clients are probably better off creating some income each year in the form of EAPs to fully utilize the student’s annual basic personal amount (BPA) and other credits.
For 2021 the highest federal BPA is $13,808. That means that a student can have taxable income from all sources up to this amount before paying any federal taxes. The student should calculate their estimated income for 2021, including any part-time income or income from a summer job. This income would be deducted from the BPA of $13,808 (plus other credits) and the difference would be the amount of EAPs that can be received tax-free in 2021.
In addition to claiming the BPA, students can claim a non-refundable tuition tax credit federally and in all provinces other than Alberta, Saskatchewan and Ontario. If we assume a federal tuition credit of $6,700 (average 2021–2022 undergrad tuition in Canada) combined with the BPA of $13,800, we get total federal credits of $20,500. In other words, a Canadian undergrad student with no other income in the year could receive about $20,500 of EAPs in 2021 and pay zero federal tax. (If the student had part-time or summer income, this amount would be reduced accordingly.)
But clients could take out even more. For 2021 the Canada Revenue Agency will permit each beneficiary of an RESP to receive up $24,676 of EAPs without having to demonstrate to the RESP provider whether such a withdrawal request is reasonable. So, the student could receive an additional $4,176 above the $20,500 and pay only minimal tax on this EAP, at marginal rates ranging from 20% (Ontario) to 27.5% (Quebec) when the student’s total 2021 income stays in the lowest provincial bracket.
For RESPs with substantial accumulated income and growth, getting the funds out at these lower rates beats being forced to take out an AIP years later, at rates that could exceed 70%.
Jamie Golombek, CPA, CA, CFP, CLU, TEP, is the Managing Director, Tax & Estate Planning with CIBC Private Wealth Management in Toronto.