This post examines how to best fund an RESP for families with their available investment money inside a CCPC (such as a professional corporation). The last few posts on RESPs have been for the rich kids with $50K in a personal account to invest. In that setting, a larger upfront lump sum contribution could be the best contribution strategy.
Those with their money in a private corporation need to flow that money out of the corp and into their personal hands to fund an RESP. That has big tax consequences and alters the math. I haven’t seen anyone on the internet attempt to dissect this. It is a complex topic. Let’s break it into digestible chunks and take it on. I have linked to some of my other posts for those seeking more background details.
Tax Features Of An RESP
An RESP has a number of features similar to a tax-free savings account (TFSA). It is funded with after-tax dollars (money in your personal hands). For those who like details, foreign withholding tax on foreign dividends in a TFSA is not reclaimable. Also, the interest on a loan taken to fund an RESP is not tax-deductible.
Other features of an RESP are similar to a registered retirement savings plan (RRSP). The money is tax-sheltered in that you pay no tax on the investment income (interest, dividends, or capital gains) during the accumulation phase. However, like an RRSP, is really tax deferral.
Investment income taken out of an RESP is taxed as regular income (not the advantaged eligible dividend or capital gains tax rates). That would be crappy for an account originally funded with after-tax dollars except for two features. Withdrawals are taxed in the hands of the beneficiary. Fortunately (sort of), students usually have little or no taxable income. That means little or no tax actually paid.
The original contributions can be removed tax-free as “return of capital”.
A unique feature of RESPs is that contributions can also be accompanied by a Canada Education Savings Grant (CESG). It applies to contributions for a beneficiary under the age of 18. The CESG is 20% of the contribution, up to a maximum of $500-600/yr and a lifetime maximum of $7200 . The full details are in an RESP basics post.
Tax Features of A Corporate Investment Account
A full description of how money flows through a CCPC is elsewhere. Here are a few points that are key to today’s post:
Corporations are excellent tax-deferral vehicles. You pay the small business tax rate up front and have more capital to invest. The remainder of the tax is paid when you take the money out of the corporation as an ineligible dividend.
The increased starting capital is allowed to grow for all those years between initially earning the money and actually paying it out. With compounding returns, this is very powerful.
Investment income in a corporation is not tax-sheltered. In fact, a rate approximating the highest personal rate is applied up front. Some of that tax is then refunded when money is moved out of the corporation into personal hands. This is called RDTOH. Similar to personal investing, realized capital gains are only taxed at half the usual rate. The tax-free half of a capital gain in a corporation can be dispensed as a tax-free capital dividend to the corporation owners.
If optimized as part of a larger portfolio and enough dividends paid out of the corporation to release the RDTOH, a corporate investment account can have very minimal tax-drag.
Can These Features Effect RESP Contribution Strategies?
In my previous post comparing general RESP contribution strategies for those with money, putting larger upfront lump sums to shelter investments from tax was increasingly advantageous for those with higher tax burdens. That was using money that would otherwise be subject to personal taxation.
The situation is different when using an RESP in conjunction with a tax-efficient corporation. Both have tax-deferral characteristics.
A corporation has excellent tax-deferral that gets nullified as we take more money out of it to fund an RESP from our personal dollars.
The corporate pay-out tax cascade.
The most common way to take money out of a corporation to fund an RESP contribution is probably to pay out an ineligible dividend. However, the effects of using salary are basically the same. The amount of money to remove from a corporation to make an RESP contribution is not a simple linear calculation.
For example, let’s say you want to contribute $2500 to an RESP and are in a 20% tax bracket. You pay out $2500 plus $500 for tax. It is actually more of a cascade because you also need to take out an extra $100 to pay the tax on the extra $500. Then, some more to pay the tax on that extra $100, and so on. This cascade of paying tax actually results in you requiring a $3150 dividend from the corporation to make a $2500 after-tax RESP contribution at a 20% tax rate. This is the other side of tax-deferral.
Larger dividends may push you into higher tax brackets, gradually increasing the proportion lost to tax. This is illustrated in the chart below. The rate that the orange tax portion widens increases with larger lump sums required. The net ineligible dividend tax rates are 20%, 22%, and 24% as $77K, $87K, and $91K respectively are breached by the larger grossed up dividends required.
Taking money from a corporation results in a tax-hit. But putting it into an RESP also results in CESG.
So, the balance of whether an RESP or corporation is better is affected by how much of the tax-hit is counter-acted by CESG. CESG is maxed out at $500/yr ($600/yr for those with lower incomes). Large front-loaded contributions over $16500 give up some of the CESG. This is because the lifetime contribution limit of $50K would be hit before all of the CESG is received.
When the alternative is a personal taxable account, that loss of some CESG with a large upfront contribution can be made up for by a longer period of tax-deferred growth. In contrast to a personal account, a corporation also has tax-deferred growth and the RESP’s relative advantage is minimal.
Comparing different RESP contribution strategies.
In my post about RESPs for Rich Kids, I described four main strategies that someone with a lump of money could use. In this post, I will compare the same strategies except with a corporate account instead of a personal account.
Strategy #1 No RESP: Simply keep all of the money in the corporation and pay it out as needed, starting at age 18.
Strategy #2 Contribute $2778/yr: Contribute the same amount for 18 years to both get the maximum $7200 CESG and make the maximum $50K RESP contribution limit.
Strategy #3 CESG Only: Contribute $2500/yr for 13 years and then $1000. This would result in removing just enough money out of the corporation each year to get the maximum CESG and leave the rest of the money in the corporation to be doled out later.
Strategy #4 Front-loading: This uses various up-front lump sums, followed by $2500/yr until the max $50K lifetime contribution limit is reached. Lump sum optimization was the best RESP contribution strategy for those who are not incorporated. Will it be for the incorporated crowd…
Simulation Model Methodology
I have not seen anyone do this analysis before and there are complexities. So, I want to lay out my methodology in the name of transparency. Some may be interested. Others might just want to trust some doc on the internet with loonie in the name of his website. Crazy.
- The RESP starts at birth.
- The after-tax value of the RESP and corporate portfolio is determined at age 18.
- CESG is added at the rate appropriate for the contribution and family income level.
- The corporate account starts with $73696 in it. This would be enough to make a $50K after-tax lump sum contribution.
- Each year, depending on strategy, an ineligible dividend is paid out from the corporate account that results in the after-tax contribution amount. Realized capital gains are also taxed within the corporation and money added to the capital dividend account. Any taxes paid disappear into the political ether.
- Annual investment income (interest, dividends, realized capital gains) in the corporation are subject to tax. It is assumed that enough dividends are paid out to live on each year to trigger the full release of the RDTOH. That refund is put back into the corporate investment account each year. I also ran the simulations with pay-out of RDTOH at the end instead of annually and it did not affect the conclusions.
- Withdrawal Strategy. RESP withdrawals are assumed to have no tax in the student’s hands. Withdrawals from the corporation are as ineligible dividends. These are spread out over four years to simulate an undergraduate degree and minimize the bumping up into different tax brackets from a single large liquidation. There is a separate general post on RESP withdrawal strategies elsewhere on the site.
- The model investment portfolio is outlined in the image below. The same investment mix was used in both the RESP and corporate accounts with no attempts to optimize asset location.
Maximizing the RESP Lifetime Contribution Limit Never Came Out Ahead
With the upfront tax bill for taking money out of the corporation, none of the strategies to contribute a full $50K to the RESP outperformed. In fact, the larger the front-loading, the worse the final outcome was. Below is a chart showing the final after-tax portfolio amounts for a CCPC owner who’s usual personal taxable income is $70K/yr.
Other Conclusions About RESP Contribution Strategies From The Above Chart
- Not using an RESP was a loser. Most corporate kids can benefit from an RESP (more on this later).
- The winning strategy was to get the maximum CESG and then stop. This was done by contributing $2500/yr for 13 years and then $1K once.
- The tax deferral of an RESP was not enough to offset the loss of tax deferral from taking money out of the corporation. The main benefit was getting the CESG.
- This was at $70K/yr base personal income for the shareholder of the corporation. What about at higher personal tax rates?
The Effect of Parental Income Level On Strategy Outcome
The tax deferral advantage of a professional corporation is greatest for those facing a higher personal marginal tax rate. This impacts the strategy outcome. For those at the highest marginal tax rates, the larger upfront tax hit and loss of the corporate tax deferral advantage may not be made up for by the CESG.
A closer look at how these portfolios change over time highlights the issue in the charts below. On the left, with a lower personal income, the tax drag from dividends being paid out from the corporation was minimal. Those taxes are made up for by receiving the CESG. Then, the RESP also grows slightly faster due to the tax-sheltering of investment income. The tax upon accessing the portfolio is less since the RESP portion is taxed in the poor student’s empty little hands.
For a higher income owner, the taxes each year are not made up for by the CESG. Even though taking money from the corp triggers more tax at the time of accessing it, there is a bigger pot to draw from. This is tax deferral in action.
The Effect of Corporate Income Level
The model so far has used a corporation that is benefiting fully from the small business deduction (SBD). The SBD makes corporate tax really low (12.5% in Ontario) and the corporate tax deferral advantage fantastic.
Ah, but the Federal government recently attacked this ability for Canadian small business owners to defer taxes with their new active-passive income limits for CCPCs. These changes will impact professionals with high-incomes or long careers where they don’t want to cut back, or if they have high savings rates.