Putting aside funds to help pay for a child’s post-secondary education is an important goal for many families. RESPs help, but using them with TFSAs can be even better.
RESPs or Registered Education Savings Plans allow Canadians to contribute to an account established to save for post-secondary education and have those funds grow on a tax-deferred basis while they’re in the account, boosted by federal Canada Education Savings Grants. Then, when a child participates in an eligible post-secondary education program, the earnings and grants withdrawn from the RESP are taxable to the student, not the contributor, and the original contributions are withdrawn without any tax implications.
While the RESP has been around since 1974, in January 2009 the federal government introduced a new, tax-preferred account that can also be used to save for a child’s post-secondary education – the Tax-Free Savings Account. Unlike the RESP, the TFSA isn’t eligible for any special grants if used to save for a child’s education, and also unlike the RESP, all funds withdrawn from a TFSA are not taxable at all, for anyone.
Both accounts have powerful tax advantages. But can they team up to provide an even better result? Here’s how one financial advisor combined RESPs and TFSAs to benefit the post-secondary education plans for a Calgary family.
Introducing Rob and Ella
Rob and Ella have three kids and were anticipating a big post-secondary education bill. A few years ago, with the support of their financial advisor Aaron Hector of Doherty & Bryant Financial Strategists, they decided to focus on funding a family RESP for their kids to help offset education costs.
For this couple, prioritizing funding an RESP meant they wouldn’t miss out on the available grant funds. The federal government provides a 20% match on annual RESP contributions with Canada Education Savings Grants (CESGs) of up to $500 per year, to a lifetime maximum of $7,200 per child (an additional grant is available for lower-income households).
The grants represent a risk-free 20% rate of return on yearly contributions of $2,500, before any investment growth.
The Family’s Dilemma: An RESP “Black Box”
Fast forward several years, and two of Rob and Ella’s three children have started post-secondary education. Both kids also have part-time jobs with a marginal tax rate of 25%, and they can’t fully eliminate the tax bill resulting from RESP withdrawals with tuition tax credits.
Now the problem isn’t funding the account, but getting the funds out while minimizing tax.
“Whenever we would withdraw funds from the account, we’d need to work through the tax consequences for the kids,” comments Hector. “Rob and Ella didn’t want their kids to have a ‘tax surprise’ as a result of RESP withdrawals, so we worked to manage the kids’ total income to ensure they wouldn’t be left with a tax bill. This meant that every year, I needed to analyze and recommend how much of each required withdrawal should be structured as a taxable Education Assistance Payment (EAP) or as a tax-free Post-Secondary Education (PSE) withdrawal.”
“The RESP had become a bit of a black box,” says Hector: “There was no easy way to know how much of the remaining account balance was going to come out on a tax-free or taxable basis, meaning a lot of recurring sharp-pencil work from me, and a lot of tax uncertainty for Rob, Ella and their kids.”
“This is when I realized we could optimize the overall family’s future tax position – while also getting much greater overall clarity around tax matters – by using their available TFSA room in concert with their RESP,” Hector says.
The Advisor’s Solution: Minimizing and Clarifying Future Tax
Here’s what the advisor recommended: withdraw the entire available PSE balance from the RESP, and shift it into Rob’s TFSA account. (As long as there is a beneficiary attending post-secondary school, there are no restrictions on the dollar amount that can be withdrawn as a PSE.) Then, all that remains in the RESP is the taxable EAP balance.
This strategy had two benefits, comments Hector:
- Tax clarity: First, it was clear that every single dollar left inside the RESP would be taxable when withdrawn. If the parents needed money for their children’s education they could take it from the TFSA if they wanted it to be tax-free, and they could take it from their RESP if they wanted it to be taxable. “Simple and elegant,” comments Hector.
- Tax minimization: Secondly, their future tax state would be improved, as the funds moved into the TFSA could now both appreciate and be withdrawn free of tax.
Here’s how this second benefit plays out with numbers:
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Before: Black Box |
Afterwards: Clarity |
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● RESP has a total value of $79,139. ○ $51,691 of contributions (eligible for a non-taxable PSE withdrawal). ○ $27,448 of grants and growth (taxable to kids when withdrawn as EAPs).
● Strategy is to leave RESP intact ● Result: ○ No tax on PSE withdrawals ○ Kids pay tax on EAP withdrawals at 25% marginal tax rate. ○ If contributions earn 5% per year, the resulting $2,585 is taxable to the kids when withdrawn. ○ If all earnings are withdrawn and taxed at the kids’ marginal tax rate of 25%, the family faces a yearly tax bill of $646.
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● Strategy is to withdraw all contributions and deposit to Rob’s TFSA. ● Result: ○ RESP has a total value of $27,448 ○ TFSA has a total value of $51,691 ○ If the TFSA earns 5% per year, the resulting $2,585 is not taxable to anyone when withdrawn – a yearly tax savings of $646.
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As an additional benefit, any excess money in the TFSA that Rob and Ella don’t require to fund their children’s education is already inside a tax-preferred account and working toward their other financial goals, such as retirement.
“In the end, this strategy – which combines the benefits of the RESP and TFSA accounts – isn’t particularly complex,” comments Hector, “although I haven't heard of anyone else using it or even discussing it. But in the right circumstances, it can make a material difference to a family’s finances.”
