After years of optimizing your RESP contributions while Mini-Me worked diligently at their studies, the big moment has arrived… Time to ship them out to school.
Before you open the airlock and jettison them from the ship, let’s look at how best to withdraw money from their RESP to maximize what goes to their education and minimize what goes back to the government.
For the basics of how an RESP works, see RESP anatomy 101. In the follow-up post to that, we compared a number of contribution strategies to optimize the value of your RESP. The Loonie Doctor Nerd Department made an excel-based RESP calculator to help you enter your own numbers to explore your personal situation.
We will use the second tab of that RESP calculator today. It’s features:
- Automatically estimates RESP value based on your contribution plan and expected returns which you input on the first tab.
- It accounts for inflation (adjustable). This keep prices in today’s dollars to help prevent seizures.
- The predicted RESP value also adjusts automatically if you change the age at which your progeny start drawing from the RESP.
- Built in income tax calculators to account for the different ways that RESP money is classified and taxed when accessed; adjustable for each province
- Accounts for income earned by student jobs
- Adjustable for costs of education and living expenses
- Tax consequences of liquidating an RESP without using it all
Optimally using the money from your RESP depends on a balance of all of these factors and the calculator helps to remove the complex math from that, so you can focus on the inputs and outputs.
When it is time to take money from your RESP, the financial institution holding your RESP can give you a breakdown of the money in the account into:
- original capital contributions
- CESG grants
- tax-free growth on investments which is called Accumulated Investment Income (AII)
The subscriber (usually the parental unit) or the promoter company (in group plans) decides on distributions from the RESP. Not the beneficiary – cancel the tickets junior.
The CESG and AII are paid out as Education Assistance Payments (EAP) when your clone is enrolled in a qualifying educational institution. EAPs are taxed as income in the hands of the beneficiary.
You can access your original capital contributions at any time tax-free and they can be paid to either support the fruit of your loins or you can take the money back and skip the fruit.
A full description of the rules around accessing your RESP money is found in RESP Anatomy 101.
With the basics out of the way, let’s explore a few RESP liquidating strategies.
Strategy 1: You are worried that Mini-me may spend too much time humping the “laaaser” instead of studying and not complete their four year degree. You want to get the EAP money out asap to avoid paying it back.
Let’s assume that you optimally made maximum contributions to the RESP, got an average real rate of return of 4%, and your beneficiary is starting a 4 year University degree in Ontario at the age of 18. Your financial institution shows you have the following balance in your RESP:
You want to get the $7200 in CESG and the $39K in AII out of the RESP and into your offspring’s hands as soon as possible. We’ll assume that their tuition and living expenses are just under $23K/yr – this is the high end of average cost in 2017 and the amount under which CRA does not need an audit. You give an EAP using the CESG and AII first. They get student jobs each summer to supplement their income. By the end of their second year, you are left with only $1830 in AII and you have barely touched your original contributed capital.
So, if they dropped out at that point, and in a fit of anger you liquidated their RESP, you would only pay a 20% penalty on the $1830 in inused AII. The remaining $49500 of contributed capital goes back to you tax-free.
Taking this cynical approach can cost you. Putting the relationship aspects aside, you will note that by front-loading the EAP money, you have bumped up your loved one’s taxable income to a point where they do pay about $6140 in income tax over those first two years. That is money they gave back to the government and is almost as much as the CESG. There are a number of alternatives:
If they did not earn student income ever, but used that time in the summers to sow their wild oats, recharge to better focus on schooling during the school year, or volunteer in an area to pad their application to Evil Medical School, then that would drop their income taxes to $4444. It would also mean dipping more into your contributed capital by a further $5500 to make up for the $8500 that they did not earn working. If your intention is that all of the RESP money goes to your kidult regardless of what they do, then this student income avoidance approach redirects $1700 away from tax and into their hands instead.
Of course, the fact that they never worked over those four years has the cost of the lost income and experience from student jobs. They would also pretty much deplete the whole RESP if they never worked over that four year period. If they didn’t work in the first two summers, but did in the second two, there would still be $14K of contributed capital left at the end of four years.
- If your kid drops out, you do not have to liquidate the RESP right away. Many make mistakes such as going to the wrong programme for them or not adapting to the independence or workload well on their own. They may go back to school later and the RESP can help them – it does not need to be closed out until their 34th year of age. Don’t do anything rash!
Strategy 2: Working on the assumption that your little angel will complete their 4 year degree as planned, you spread out their EAPs evenly over the 4 years.
We’ll assume the same initial RESP value, education/living costs, and student job income as used in the initial modelling of the first strategy.
As you can see, with this approach of spreading out rather than front loading the EAP money, you lose $4400 to tax compared to $6140 in Strategy #1, for a savings of $1750. This means you have $21500 of contributed capital at the end of four years that is available tax-free.
If they did not earn any student income at all, they would only pay $300 in tax over the four years, but would need to use more of the contributed capital, leaving them $6000 at the end of four years. That means with not earning $20500 through work, they will have to use $15500 of capital to make it up. That is an efficient use of capital if the time not working is used wisely. What is a wise usage of time is certainly a judgment call.
A good problem to have – what to do with the excess capital contributions.
- In these examples, we have assumed a high RESP savings rate – maximizing the $50K contribution limits. While this should be readily achievable for a high income professional with their financial house in order, it may not be for everyone. You could decrease your contributions while building up the RESP so that it ends up being smaller at the time of withdrawing. Adjustments in the contributions tab of the calculator can give you an idea of what different contribution reductions would produce.
- You could distribute more capital each year that your offspring stuffs into their TFSA and invests in growth oriented ETFs. The sooner they start growing TFSA space, the better for them. It is important to note that TFSAs count as assets when calculating student aid grants, such as OSAP in Ontario. If your household is in the <$170K/yr income, you should check that the TFSA would not result in lost OSAP grants using the OSAP Aid Estimator.
- Keep the money in the RESP generating tax-free growth, to help fund a second degree or diploma or another member if a Family RESP.
- Take it out and use it to maximize your TFSA or RRSP, if for some reason you have not already done so.
What if things really go off the rails and there is CESG or Accumulated Investment Income left in the RESP after the beneficiaries have been educated or no longer require an RESP?
This would be accessed as an Accumulated Income Payment (AIP). To get an AIP, the plan must have been in existance for over 10 years and the beneficiaries are over the age of 21 or deceased.
Because the CESG money was a grant and the AII has not been taxed, the AIP will be subject to your income tax rate plus an additional 20% tax. You can avoid or reduce this tax by transferring the AIP money directly to your RRSP if you have room, up to a maximum of $50K.
If you don’t have RRSP contribution room, but are generating more by working, you can wait a few years and then do this as long as you close the RESP before the last beneficiary turns 34. You must close out the RESP after taking the AIP.
If you have to take an AIP, then the bottom right corner of the RESP calculator has an income tax estimator to show how much extra tax it might cost you.
One of the concerns people often have about using RESPs is that they are worried about being to get their money out.
Hopefully this work with the RESP calculator has shown you that it is relatively easy to get your money out with a self-directed RESP. Group RESPs can be trickier since you don’t control the distributions. With a self-directed RESP, you have the flexibility to adopt a strategy that maximizes the tax efficiency of funding your beneficiary’s education and adapt it to their career and life plans.
Hopefully you find the calculator helpful in looking at your own situation when the time comes. Kleenex not included.