How to best withdraw the funds from the large RESP accounts?
Every year we are getting questions about strategies to tax-effectively withdraw funds from a registered education savings plan (RESP). Given the bull market of the past decade, some parents have noticed that there are substantial funds in their RESP and wonder if there are some strategies that could be employed to withdraw those funds with minimal (or, in some cases, zero) tax.
RESP Account consists of:
Max contributions - $50,000 per child over the life of RESP account
Canada Education Savings Grants - up to $7,200 per child
Growth on the account over the years
There are three types of payments that you can take from your RESP:
Refund of Contributions (ROC) - This can be withdrawn at any time, tax-free, as you have contributed with your own after-tax dollars.
Educational assistance payments (EAP) - EAPs consist of all gains, income and government grants (CESG), All EAP withdrawals are taxable to the student when paid out. (Usually lower marginal tax rate)
Accumulated income payments (AIP) - Represents the amount of money that is left in the RESP account after the student has finished his post-secondary education or if he/she has never pursued post-secondary education. There are two conditions when you are allowed to get your AIP: First, an AIP can only be made after the 9th calendar year following the year the RESP was opened and only if all living current and former beneficiaries of the RESP have reached the age of 21 and are no longer eligible to receive EAPs. Second, you can receive an AIP in the 35th year of the plan — that is the maximum length an RESP can typically remain open. The best solution is to avoid getting AIP at all because it comes with a hefty tax bill. Those payments are taxed at your current marginal tax rate, which is usually higher than your child'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-per-cent penalty tax on top of your regular tax rate. For a high-income BC (grand) parent, this could translate into an effective tax rate of 73.50% on any AIPs. You may be able to roll over up to $50,000 of AIPs into your RRSP if you have unused contribution room. In this case, the additional 20-per-cent penalty tax will not apply.
This brings us to the question of how to best withdraw funds from a large RESP 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%.
One of the solutions is to fully utilize the student’s annual basic personal amount (BPA) and other tax credits.
The enhanced federal BPA is $13,808 for 2021. That means 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 and summer income. This income would be deducted from the basic personal amount of $13,808 (plus other credits) and the difference would be the amount of tax-free EAPs that can be received in 2021.
That said, there is no requirement that the money taken out of the RESP be specifically used towards tuition, books, etc. As long as the child is enrolled in a qualifying post-secondary program, “reasonable” EAPs can be paid to the student and the student can then choose to use the funds to pay for rent, food or any other expense that assists the student to further their post-secondary level education.
For 2021, the Canada Revenue Agency will permit each beneficiary of an RESP to receive up to $24,676 of EAPs without having to demonstrate to the RESP provider whether such a withdrawal request is reasonable.
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 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 tax. If the student had part-time or summer income, this amount would be reduced accordingly.
Given the “reasonable” EAP limit of nearly $24,676 in 2021, the student could then receive an additional $4,176 and pay only minimal tax on this EAP, at marginal rates of around 20%. if the student’s total 2021 income stays in the lowest provincial bracket.
Getting the funds out of RESPs that have substantial accumulated income and growth at these lower rates beats being forced to take out an AIP years later at rates that could exceed 73%.
- Your Creed Capital Management team