Optimizing RESP Withdrawals

July 20, 2018 LD Editorial Note: There is much written about RESP contribution, but less about withdrawal. With the next school year looming, I have seen this topic coming up. I originally took a stab at it last January, but have gradually unearthed enough new information since then that I decided to basically re-write the post and break off chunks for later posts to make it digestible. I also radically upgraded the corresponding tab on my RESP calculator.

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 to best 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 online RESP contributions calculator for you to enter your own numbers and explore your personal situation. There is also an online RESP withdrawal calculator to go with this post.

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 (the money you put it)
• Canadian Education Savings Grants (CESG)
• Tax-free growth on your investments which is called Accumulated Investment Income (AII)
• There can also be Canada Learning Bonds for lower-income families and some provincial grants that I have not accounted for in this post.

Basic RESP Withdrawal Facts:

• 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.
• The proportion of the EAP payment that comes from CESG vs AII is calculated by the financial institution holding your RESP. The EAP formula is a bit confusing, but can be simplified.  Basically, it works to ensure that you cannot give an EAP greater than your AII & CESG (no, duh!). The formula makes sure that to get the CESG, you need to draw down both your CESG and investment income.
• EAPs are taxed as income in the hands of the beneficiary.
• You can access your original capital contributions at any time tax-free. Do not do this before your beneficiary is attending a qualified institution because that could result in a loss of CESG. The capital returned can be used 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.

What are we trying to balance with our RESP withdrawal strategy?

Risks of drawing EAP too slowly:

• If your kid has a short scholastic career or drops out never to return, then the leftover CESG is lost. Any of the accumulated investment income that you cannot roll into your RRSP gets heavily taxed. More on that later.
• Using a family plan can attenuate some of that risk. Unused investment income can be used by the other beneficiaries. Hopefully, one of your little fledglings won’t go splat when they leave the nest. The CESG is still limited to $7200/child.

Risks of drawing EAP too quickly:

• Drawing a large EAP can increase your progeny’s tax bill. Enough part-time or summer job income can bump them up tax brackets.
• We also want to avoid drawing an EAP above the level that triggers a CRA audit. The official level is ~$23K/yr and indexed to inflation according to the CRA website. However, $20K is frequently mentioned in the various internet articles that I have read.

So, the main variables that you can try to optimize for are projected length of education and projected income from jobs.

Optimizing for Projected Length of Education

Optimally liquidating an RESP is a bet on how many years your clone will be drawing from it. Most high-income professionals are highly educated. However, that is not the only path to happiness and success in life. We need to be honest with ourselves about what our kids are most likely to do and succeed at. Yes, we need to push them. However, our primary goal in that is to support them to reach their full potential. Being honest about whether our kid should or will complete a longer degree not only helps us to support them. It also helps us better decide how to liquidate their RESP.

For those likely to have a short training period (2 years or less), it is usually best to get the CESG and investment income out as fast as possible. This results in slightly more tax up front. However, it prevents losses from unused CESG and AII taxation.

For those likely to have longer times in school, smoothing out the EAP payments over 4 years can decrease the loss to tax by a couple of thousand dollars. It may even eliminate it, depending on whether there is other student income.

To best plan your RESP withdrawal strategy, you need to have an honest discussion with your clone about what they plan to do. This also needs to be a realistic plan based on their interests and capabilities to execute that plan. You may want Mini-me to attend Evil Medical School like you did, but they may be destined for a different path.

Optimizing for Projected Student Income

For those with a smaller RESP, earning some student income is likely necessary to meet cash flow needs. Also, with less money to come out of the RESP, tax rates are likely to be essentially zero. For those blessed with a large RESP, as would be common in a high-income family, the dilemma is a bit different. There are still minor financial considerations, but the bigger issue is how to spend the money wisely.

On the financial side, there are two main strategic opportunities.

First, is optimizing their first year.

The approach to their first year can vary. Remember, taxes are on a calendar year basis and the school year straddles that. Students who start college or university in the Fall after high school graduation will have likely had a low income from their summer job. In later years, they have a longer break and tend to get better-paying jobs. Paying out as much EAP in that first calendar year could be advantageous.

The maximum EAP for the first 13 weeks of enrollment is limited to $5K. That would get you to the end of November, or the beginning of December. So, there is a small window for a second EAP in that first calendar tax year.

Conversely, students who took a year or more off to work before going on to post-secondary education may have a higher income in their first calendar tax year. They may want to shift more of their EAP to later years when they have a lower earned income. Of course, that only works provided that they are in a long enough training programme to liquidate the CESG and AII portions of their RESP before graduation.

The second consideration would be to maximize the tax-free distributions of EAP.

For those with a smaller RESP. Try to pay their EAP to top up any earned income to the cusp of their tax-free personal amount. This is $10-12K/yr.

With a large RESP, we will likely need to give large EAPs simply to get the CESG and AII paid out over the typical university degree. These will easily use up the student’s tax-free personal amount or more each year. So, any income earned at a student job would be taxed at a rate of ~25% for most provinces (20% in Ontario).

The tax bill when an EAP and earned income is over the personal amount can still be zero.

Even though a student’s income over their personal amount will incur some tax, they may still have a net tax bill close to zero. This is because they can claim the Federal Tuition Tax Credit. This is a non-refundable credit that reduces their tax bill by 15% of their tuition cost. If they do not use it all, it can be carried forward to another year. Alternately, up to $5K tuition credit ($750 tax savings) can be transferred to a spouse, parent, or grandparent in the same year only.

A student who earns less money over their personal amount will lose less money to tax.

That said, the amount of extra tax incurred by some income above the personal amount, but still in the first tax bracket, is very small. See the chart to the right for perspective. Further, if you paid $6K tuition and applied the credit from that, you would be left with only the provincial portion of the tax bill ($350). Some provinces (AB, MB, PEI) still have a credit that would eliminate the provincial tax also.

Although a student may have a tax bill close to zero now because they apply the Tuition Tax Credit. Eventually, they will still pay the same total tax over the course of years – since that credit could have been carried forward for use in a future year instead. It is best to use the tuition tax credit as soon as able because there are some ways to lose tax credits later, if not careful. A student working less simply to pay less tax may be letting the tax tail wag the dog.

Working has experiential benefits and more money is more money – even if some is lost to tax.

The tax loss is very minimal. Further, they will also consume more of the money in the RESP if they earn less income from employment. The money in an RESP is a pool of financial capital that we want to use to increase our beneficiary’s human capital (earning power). Experience gained from quality employment can increase their human capital, as well as financial capital. If you have excess money in an RESP, think of how it can be best used to support your beneficiary’s long-term personal and financial growth. That is a complex personalized decision that I will expand on in a future post.

What if Buzz gets too buzzed and there is beer left in the RESP Keg?

It depends on the nature of the beer. If it is excess capital contributions, that is a good problem to have because you can still drink it.

Floaty chunks of CESG debris – not good, that needs to be removed (the government will take that back).

If there is foamy accumulated investment income from your frothy investments, the government will want to skim that off also with penalty taxes.

A good problem to have – what to do with the excess capital contributions.

It is possible that a high-income family could optimally build a large RESP that provides for the education of their children and still has money left in it. There are several ways to approach this first world problem:

• 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.
• Distribute more capital each year (tax-free) for your offspring to stuff into their TFSA. That could have the benefit of giving them experience investing. Plus, the sooner that they start growing their TFSA, the better for them.
• It is important to note that a TFSA counts as an asset when calculating student aid grants, such as OSAP in Ontario. If your household is <$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. It can be used to help fund a second degree or diploma or another member if it is a Family RESP. You do not have to close out an RESP right away. However, if your beneficiaries are 100% done, then you will want to avoid tax penalties later.
• Take it out and use it to maximize your own 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?

Residual CESG and AII is accessed as an Accumulated Income Payment (AIP). To get an AIP, the plan must have been in existence for over 10 years and the beneficiaries are over the age of 21 or deceased.

The CESG money was a grant and the AII has not been taxed. So, the AIP will be subject to your income tax rate plus an additional 20% penalty 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 withdrawal calculator has an income tax estimator to show how much extra tax it might cost you.

Summary:

• Your RESP has three pots of money to access.
• You should have a frank conversation and honestly consider the likely length of training to decide on your strategy. This could mean getting the “at risk” CESG and Accumulated Investment Income pots emptied out as quickly as possible versus as tax efficiently as possible.
• The contributed capital pot can be accessed at any time, once they are enrolled in a qualified programme, and that gives flexibility.
• Consider student income in your planning, particularly in their first year.
• Consider other uses for excess RESP capital, like supporting others in a family RESP, getting your kid started with investing in their TFSA, or making up for empty space in your own registered accounts.
• If the plan goes off the rails and leaves CESG and/or AII in an RESP, there can be tax penalty. However, you do have some option to minimize them.