RESPs For Canadian Corporation Kids – Part 1

professional education savings plan

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.

education savings incorporated professional

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.

resp vs dividends for education

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.

Could the use of an RESP come to the rescue for those naughty high earning, hardworking, big savers? Find out in RESPs for Corporate Kids – Part 2!

12 comments

  1. Love the post LD. Great financial mapping. Too bad our kid is already finished university!

    You could just have your kids work for the Corp and help you out or they could get another decent paying job as they’d likely pay no tax. Kids are no different than adults, usually if they have more $ available they just spend it. Plus if they have skin in the game they consider their educational choices more carefully.

    Fun analysis

    1. Hey Phil,

      Congrats on the kidult launch! That is a great comment.

      I have focused on the math of an RESP in these posts. However, it is important to step back and really think about what the goal of an RESP is. It is to help our kids develop skills to become happy, independent, successful adults. Some of that may be formal education, work-training, and life-training. Funding can be a mix of savings, cash flow, jobs, loans, or maybe even scholarships. It is interconnected and will be a different mix for every kid.

      One of the biggest lessons that I learned in University was actually how to live on a defined and restricted budget. We didn’t have excess money, but for our kids we will. Our plan will be to have our kids on a regular-sized budget and teach them this also. We will use some of the excess money to teach them about saving and investing. Probably via their TFSAs. One of the things I needed to learn about later in life was how to spend wisely when we actually started to have excess money. I had no experience with having extra money and how to decide about how to use it until my early 30s.

      We also expect our kids to get jobs. However, having extra cash available could mean that they can take a higher-skill-developing job rather than the higher-paying one if that becomes a factor. Maybe even a volunteer position if it advances their goals. Of course, on the other side, having a really crappy summer job can be pretty motivating to not have that be your final destination. For me, it was tree-planting in the swamps of Northern Ontario. Paid well, but it was brutal!

      -LD

  2. Awesome Series LD!

    My favourite thing that can happen in finance is when you find out you did something right out of a blind guess!

    I came out of residency when there would still be the option for paying dividend income to children when they were 18 out of the Corp .

    It felt like something that was a bit too good to be true, so I decided to hedge my bets by investing the $2500/ yr per kid even though it meant a slightly bigger personal tax.

    I always assumed I was taking an unnecessary tax hit for the hedge but it turned out for the best!

    Congrats on doing a really novel piece of research into a topic that few financial planners will ever put in the due diligence to prove the optimal approach.

    Canadian professionals everywhere owe you our deep gratitude!

    Cheers
    FFMD

    1. Thanks FFMD!

      I would love to say that I did everything optimally, but I didn’t. I got the big stuff right by starting early, avoiding group plans, and using low-fee DIY investing. So, not a big deal in the end. I hope that this series helps inform those coming after me to be able to make more deliberate decisions.
      -LD

  3. LD,

    This made my head spin, but eerily enough, I could follow the logic if not necessarily the acronyms (CCPC isn’t the former Soviet Union?!).

    You are winning the prize for modeling granular financial details as a blogger, and I’m digging it.

    One question, though – with an 18 year time horizon, is there a reason for a 60/40 portfolio, or is it simply to keep comparisons stable over models? I ask because I’d consider being very aggressive with the funds early on, and transitioning to a more conservative asset allocation as you near the withdrawal date.

    Fondly,

    CD

    1. Hey Crispy Doc,

      Yes, the 60/40 is commonly referenced and was simply to be consistent for illustrating the points. I am working on a tool that allows you to customize to your own asset allocations/expected returns.

      In terms of aggressiveness, that is more a question of “investment” strategy (risk/return) rather than “contribution” strategy (taxes/return/grants). I plan to tackle RESP investment strategy separately. If one is going to depend solely on the RESP for educational costs, then aggressive to start with later transitioning to conservative may be wise. For those who can draw from a combination of RESP, cash flow, student jobs, and other accounts to fund education – it probably makes more sense to think of the RESP as just another account type in the whole portfolio (or it is basically a mental accounting trap). The RESP role in a larger portfolio may be best used as aggressive right through (like a TFSA) or perhaps conservative to keep bonds out of a corp over the tax penalty zone. Another layer, that will take more thinking and a couple of posts at least to work through.
      -LD

  4. Hey LD!

    I never started an RESP bc I was too lazy to bother. I told my kids to go to the local university and get a job. It works like a charm.

    The kids are more aware of their costs and definitely have more “skin in the game’. If they need more than what they can earn during their jobs, I promised to lend it to them for zero interest until they get a career later on.

    Because for me, it is never about what degree they get but can they learn the skill of taking care of themselves.

    I always believe having limits are healthy. Thus I don’t bother optimizing it all that much for them.

    1. Hey Dr. MB,

      As one of those parents still muddling my way through, I actually think most of what is going to happen to kids in the post-grad years around their motivation and self-reliance is determined way before then. The ones that I have seen who struggle the most are those who had their decisions made for them by their parents and/or constantly get bailed out by their parents. This starts long before high school even. I agree that some struggle and failure is key to ultimate success. The distance to fall is less when you are short and kids mend easily. I remember reading a study once about how kids who free-play on playground structures develop better risk-assessment and decision-making. High-school and the early training/working years offers a financial equivalent for this.

      -LD

  5. This is a great analysis, and I think you really are the only guy on the internet who’s tackled it. Thank you and keep up the great posts!

  6. Dear LD
    Another great post! I thought I had RESPs all figured out and your modeling shows I have missed the mark a bit.

    With our personal draw/income much higher than your cutoff of 150K/yr I think I’m going to stop making draws for further RESP contributions.

    I realize it’s not exactly related but I have questioned the value of TFSA’s for high income earners for the same reasons. I know from your other post on TFSAs you must be a fan of them, but I’m not convinced they win long term with the big up front tax hit. Perhaps you can comment and perhaps I’ve just done my math incorrectly. There is a nice basic simulator online which suggests for high income CCPC owners it takes almost 30 years for the TFSA to surpass the investing within the PC.

    I’ve always been attracted to the simplicity of keeping the money investing within the PC, especially if unforeseen circumstances prevent me from working full time for my full planned working career.

    Thanks again.

    1. Hey Cowboy Cutter,

      I actually don’t think it is necessary to get any of these things perfect. However, if the effort is minimal then – hey, why not try. I am big fan of TFSAs. While, yes, the tax hit may take a while to make up upfront, the timeframe for a TFSA is much longer.

      Also, having money spread out in several account types has other benefits. Less tax drag from the corp passive income limit (more on this next week), less risk of getting clobbered by a tax law change (we just saw this), and multiple pots to draw from depending on circumstances are the big ones for me.
      -LD

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