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Putting the RRRRR! in RESPS – What To Do If Your Kids Aren’t Too Cool for School, Part 2

In this second installment in my series on how to pay for junior’s degree in ornithology or whatever other educational pursuits float his / her boat without hopefully jeopardizing your own retirement, I will focus on the most common strategy: Registered Educational Savings Plans (“RESPs”). As I wish to focus as much of my time on how to squeeze as much out of these plans as possible, I won’t provide you with a comprehensive catalogue of all things RESP, noting that there are many great resources out there to do just that.

All the same, in order to understand how to squeeze the most of RESPs, it is vital to understand the basics. To begin, it’s possible to contribute up to $50,000 per child into a RESP, either in a stand-alone plan for that child or as part of a family plan for all your children. Although there are technically no limits regarding how soon you can invest the full $50,000 in contribution room, the government only provides 20% matching through what it calls “Canada Educational Savings Grants” (“CESGs”) on the first $2,500 contributed each year (i.e., $500 in yearly grants), up to a lifetime max of $7,200 in CESG grants per student, although here are also additional funds for low-income families I won’t discuss further. As one exception, if the family hasn’t made its full $2,500 in yearly contributions in the past, the government will provide an additional 20% matching on the next $2,500 in catchup contributions made in that year.

Unfortunately – and this is a big drawback – any contributions that don’t trigger government matching in the year of contribution cannot be carried forward to earn CESG grants later. In other words, CESG grants are based solely on how much has been contributed that year, with no credit for extra contributions made in years gone by.  Accordingly, each family needs to decide what is more important – maximizing CESG grants over the lifetime of the plan or getting as much in the RESP as soon as possible in order to maximize tax-deferred compounding. As a result, as we all love free money or have other things we can do with money that won’t receive government matching, most families are content to cap contributions at $2,500 per year (ignoring any catchup contributions) even though this means that it will take almost 15 years to max out government matching and that they will have far less money compounding in the plan than might have otherwise been the case.

Once inside the RESP, the person funding the plan (“the subscriber”) decides how to invest all the contributions and grants, with essentially the same investment choices that are available within an RRSP or TFSA. All of the money inside a RESP is commingled and grows tax-free. Upon withdrawal, the CESG grants, income and investment gains from all sources are lumped into a single category called “Educational Assistance Payments” or “EAPs.” These are taxed as income in the child’s hands, assuming that child is enrolled in a full-time educational program of more than 13 weeks, with special rules for disabled and part-time students. On the other hand, the original contributions from the subscriber (called “Post-Secondary Education Payments” or “PSEs”) are tax-free withdrawals and can either be paid to the student or returned to the subscriber, with the subscriber calling the shots.

When it is time to make withdrawals, it is also the subscriber who decides when, how much and what portion shall be taxable EAPS or tax-free PSEs. There are no restrictions regarding when the tax-free PSEs are withdrawn once the student is also eligible to withdraw taxable EAP payments. For EAPs, there a few more limits, but not all that many. First, EAP withdrawals are capped at $5,000 during the student’s first 13 weeks of a full-time program ($2,500 for a part-time student) during a calendar year. In other words, a regular student attending school full time until graduation with only summers off will only be capped during the first 13 weeks of their studies, as they will always have attended school for 13 weeks within the last 12 months.

Also, the student must be deemed a Canadian resident or they will need to repay CESG grants, although studying abroad doesn’t necessarily mean losing Canadian residency – you will need to investigate this in advance if junior has Harvard in their sights. Ultimately, if the student become a non-resident, the previously paid CESG grants will need to be repaid and the EAP will also be subject to Canadian withholding tax of up to 25%, depending on junior’s new country of residency. The only other limit is a yearly cap for receipt-free EAP withdrawals. This limit will be $24,676 for 2022 and is indexed to inflation. Withdrawing more than this amount is possible but means justifying the extra expenses to the plan administrator.

If there is extra EAP money left when the child has completed their education, the subscriber can roll up to $50,000 into their RRSPs if sufficient contribution room remains, but without getting a tax deduction on the transfer. If there is another student in the works, it may be possible to use some of the remaining EAP for that person’s studies. Otherwise, the remaining EAP balance is taxed in the subscriber’s hands as income at their marginal rates with an extra 20% tacked on, which means an effective tax rate of over 70% in some cases!  Accordingly, as I discuss below, I strongly suggest focusing on withdrawing taxable EAP payments as soon as reasonable in order to limit the chance of this unpleasant surprise at a later date.

Although I will now focus on the promised RESP maximization strategies, I just wanted to provide a final caution that I’ve vastly oversimplified things. You will need to read up on the background details on your own or get your financial advisor to fill in the missing pieces, as well as summarizing the pros and cons of each of the strategies below that apply in your particular situation. Caveats aside, here are my suggestions:

Is the CESG Grant Worth the Sacrifice?

Decide whether it’s worth trying to maximize the $7,200 in lifetime CESG grants. Although free money is a wonderful thing, this particular windfall comes at a cost – many years of lost compounding of investment gains inside the plan, since maximizing government grants means delaying full funding of the plan until the child is 15. Accordingly, some advisors recommend contributing the full $50,000 per child as soon as possible after cutting the umbilical cord and forgoing all but the first year of government matching. Assuming a plan grows at 6% per year, a max-funded plan would grow by $3,060 in its first year per year vs. $180 for a plan capped at $2,500 in contributions. In other words, the extra sheltered growth in the first year is already more than the next 5 years’ worth of CESG grants and this disparity will continue to grow as the RESP grows.

Of course, is essential to consider what else you could do with the money instead rather than filling up the RESP. For example, the money might be better deployed filling up TFSAs or RRSPs, paying down debt, or putting the money towards the other educational funding strategies like permanent life insurance, in-trust accounts or a family trust.  There is not a simple one-size-fits-all answer to this riddle, but it remains a question worth asking. In some cases, filling up the RESP strategy as soon as possible may make more sense for grandparents with disposable funds and OAS / estate tax concerns who are interested in leaving a legacy outside their Wills rather than moms and dads saving for their own retirements.

As a final thought, if there is a good chance that the student may no longer be a Canadian resident when it’s time to start withdrawing RESP funds, the CESG grants will need to be repaid anyway. Accordingly, for those students, it’s far more important to get as much money working inside the plan as soon as possible than trying to maximize government grants the student may not get to keep anyway.

Contemplate a $14,000 Bonus Contribution

If max-funding a RESP asap isn’t appealing, or possible, consider at least making an extra $14,000 one-time contribution instead. It won’t affect CESG grants but will increase the money inside the plan available to compound. This is because the lifetime funding limit is $50,000 but grants are offered only on the first $36,000 of contributions. Accordingly, no matter how you slice it, it is impossible to get full matching if you fill up a child’s RESP to the bursting point. As a result, if you’re confident that you will be able to keep making regular $2,500 in yearly contributions going forward and have the funds available, consider putting in this extra $14,000 as soon as possible, as it won’t affect CESG grants and increases how much money is in the plan to compound.  On the other hand, before even making these bonus contributions, carefully consider whether this is the most tax efficient use of your money. For example, if you haven’t maximized TFSA or RRSP funding, investigate these alternatives as well.

Stick the Wealthier Parent with the Bill

Have the higher income parent fund the plan even though it often makes sense for both parents be joint subscribers for estate planning purposes. That potentially frees up more of the lower income parent’s money to invest in their hands at their lower tax rates, which means more money for everyone, except the government.

Avoiding Estate Hassles by Having the Right Person Contribute

If grandparents want to assist, consider gifting the money to their children and then having them making the contributions on behalf of the grandkids to avoid estate planning hassles, since RESPs don’t have beneficiary designations. On other hand, if worried about the children’s marriage, investment acumen or financial situation, grandma and grandpa may decide to become the subscribers despite the eventual estate planning hassle. If they make this choice, be sure to include proper language in their Wills specifying what happens to the RESPs and who will manage them, as RESPs are generally considered to be an asset of the deceased rather than property of the student. I typically include language instructing executors to continue managing the RESPs for the students and using it for its intended purpose when the time comes. By the way, the need to mention RESPs in a Will is true for anyone named as a subscriber, not only those in their 70’s, 80’s and 90’s.

Mix It Up as School Time Approaches

Make changes to the RESP asset mix as the child gets closer to university. In particular, be strategic about realizing gains inside the plan around that time and rebalancing towards less volatile investments as the time approaches to start withdrawals. I don’t want any of my clients to have to liquidate RESP funds during a market dip just because the correction coincided with junior’s first tuition payment. Accordingly, holding boring but safer investments for at least the portion of the RESP the student may need over the next year decreases the chances of unpleasant investment surprises and the need for the student to eat far more kraft dinner than was originally anticipated.

Talk to a Lawyer or Accountant if a Move Is on the Horizon

Get tax advice if you are planning to move abroad while funding a RESP, particularly if moving to the U.S., to determine whether it makes sense to maintain the plan and to ensure that investments inside the plan aren’t subject to extra U.S. taxation, particularly if holding Canadian mutual funds.

Be Careful and Ask Questions if a US Citizen Living in Canada

Although RESPs may still be worth doing if you’re a US Citizen living in Canada, particularly due to the CESG grant, it’s worth getting expert advice before setting the wheels in motion, especially if the future university attendee may become non-residents while studying nuclear fusion or Elizabethan poetry, and are thus forced to repay CESG grants anyway. The US doesn’t recognize RESPs, which means that a US citizen subscriber will continue to declare and pay tax on gains and growth inside the plan. As a result, it makes sense for a non-US citizen spouse to be subscriber, although if you’re currently a single American who wants to set up a RESP for your kids, this isn’t a reason to take your romantic relationship with the nice Canadian down the street to the next level. Instead, this may be one of the times where tapping a grandparent or other relative who doesn’t have Uncle Sam concerns to be the subscriber if possible. If the RESP is already in place or there is realistically no one else who will be the subscriber, US citizen subscribers owning Canadian mutual funds or ETFs inside the plan may at least want to stay clear of Canadian mutual funds or ETFs due to the punitive taxation US citizens in general face when owning these investments.

 Finally, if you are a US citizen subscriber of a RESP but you have someone else without American ties who is willing to be a subscriber to a new plan, you can have them set up a separate RESP for the lucky child. Future contributions and grants can be funneled into that plan instead, thus lowering your own future tax bill. Although it is possible to set up as many plans as your heart desires for any aspiring architect, the lifetime CESG grant limit of $7,200, and the $50,000 contribution limits must be shared across all plans set up for them.  As a result, it is vital to ensure that the overall funding limits are never exceeded. To hopefully avoid this problem, tell whatever financial institution is administering the new plan how money and grants were paid into the original RESP when the new plan is created. You may also need to tell whoever is administering the old plan about this as well, which might also include instruction for them not to apply for the CESG grant for the current year if money was contributed to both plans in order to avoid unintentional double-dipping.

Withdraw the Tax-Free Portion as Soon as Practical

Consider withdrawing the tax-free PSE from the student’s RESP if they qualify for EAP payments as soon as practical, such as the year the student turns 18. Look at other ways of using the money, such as investing it in the student’s name. Although there are a lot of great advantages to RESPs, the fact that every taxable withdrawal is taxed like interest is not one of them. Assuming that you trust the student, having the unused PSE funds invested in the child’s name in a non-registered account can make the money go further, since investments generating dividends and capital gains will now benefit from these tax advantages.  In fact, in provinces such as BC, eligible dividends taxed in a starving student’s hands may actually put money in their pocket, as the dividend tax credit in the lower tax brackets is larger than the tax owing on those dividends. The extra tax credit can be used on the taxable portion of RESP withdrawals or even allow additional withdrawals without incurring tax. As an extra bonus, since we ultimately do not want any taxable income left in a RESP when the student is done school, reducing future taxable growth inside the RESP by pulling out PSEs asap can help guard against the scary tax bill that might otherwise at a later date.

Use Tax-free Withdrawals to Fund the Student’s TFSA

Instead of investing PSEs in child’s non-registered account, consider using some of the RESP withdrawals to start filling up the student’s own TFSA instead. Not only will that money grow tax-free, but any later withdrawals will increase the student’s tax sheltering room for later in life. Just be sure to consider the costs in setting up and maintaining the TFSA. In some cases, it might mean waiting until the student has a few years’ worth of contribution room before the potential tax savings outweigh the administration costs.

Use the Tax-Free Withdrawals Yourself

As a third way of using extra PSE withdrawals, consider using the money for your own or your other children’s registered plans. If the subscriber has unused RRSP or TFSA room, they may wish to take back their original contributions and use the money for those purposes, particularly if it appears that the student won’t need all of the RESP funds to complete their education, or they are using other educational funding strategies to help with those costs. If the family has younger children who haven’t received all of their CESGs, mom and dad may even want to use the money withdrawn from the older child’s RESP to contribute to the younger child’s plan so that they essentially get CESG grants on the same money twice while freeing up more of their funds for other purposes. On a related note, even if not the most tax efficient solution, having the subscriber invest the money rather than the student may be the right choice for some families if junior isn’t that great managing money.

Withdraw the Taxable Money Aggressively but Strategically

Try to draw down the student’s taxable EAP money as soon as reasonable without paying too much tax along the way. Since the tax bill on any income and grants left inside the plan after graduation can be subject to scary high taxation, getting the money out sooner rather than later reduces the likelihood of this nightmare scenario. Likewise, if there is a chance that the student may complete part of their education abroad and lose their Canadian residency status, getting more EAP money out before that happens can also mean huge potential savings for the family. It isn’t like the student necessarily needs to spend the money right away – as noted earlier, the student can invest the money in their own name instead, which can offer additional tax savings vs. leaving it to grow in the plan.

On the other hand, keep an eye on the student’s taxable income from other sources before deciding how much EAP dough to withdraw. It usually makes sense to keep the student in the lowest tax bracket for their province of residence. By reviewing the student’s expected taxable income for that year and the year ahead, you can better decide how much EAP to withdraw and when. For example, a student who worked full-time or had two co-op terms during one year may pay less taxes if there was a big EAP withdrawal the following January but a far smaller one this year, even though it means not drawing down the taxable portion as soon as absolutely possible.

Double Check That You Aren’t Mistakenly Withdrawing Too Much CESG From Family Plans

Be extremely careful regarding CESG payments allocated to each student in a family plan. The main drawback to these plans is that it is possible to mistakenly pay out too much in EAPs to the older children and trigger penalties. EAP payments are a blend of profits and government grants (CESGs), while each student can only receive a maximum of $7,200 in CESGs. As any EAP payment is a blend of those two portions determined by a convoluted government formula, it is very difficult to know when a student has reached their CESG payout maximum. Plan administrators are responsible for tracking this on your behalf, but mistakes are easily made. Accordingly, review how much that student has already received in CESG payments with the institution and whether the planned withdrawal will put the student offside before making any withdrawals.

Conclusion

Although RESPs are a wonderful savings vehicle for many children’s education, knowing how to get the most out of them can be the difference between good and great. Due to rising educational costs, particularly if junior wants to collect as many letters behind his or her name as possible or study in places where people don’t say “eh”, however, these plans may not be able to fully finance every student’s full education, particularly in light of the funding and CESG grant limits. Accordingly, parents, grandparents, uncles and aunts may want to consider other ways to fund educations as I briefly summarized in the previous article and which I will describe in more detail in the days and months to come.  Although RESPs may be a key component in an educational savings strategy, they are certainly not the only game in town.

What To Do If Your Kids Aren’t Too Cool For School: Educational Funding Strategies for Tax Stingy Families

It takes a lot to pay for an education these days, without even considering all of the bonus expenses in addition to paying for tuition and textbooks. And it’s been getting harder. Tuition costs have been consistently increasing at a rate higher than inflation and some of the previous tax-efficient funding options, such as paying dividends to students over 18 from the family business, are no longer on the table in most instances. Adding to the pain, tax rates for higher income earns have increased drastically over the last 5 years, making it that much harder for these families to accumulate and grow enough sufficient funds to put the next generation through school, particularly when saving for multiple children. And let’s not even talk about how the cost of housing eats into many family’s savings plans. Although a good education can be priceless, actually paying for it may be beyond the means of many. Alternatively, the resulting student debt can leave many struggling students financially crippled and stressed for years to come.

Although there is no universal silver bullet that can save the day or convert pennies into portfolios, there are some strategies that can at least make life slightly easier and more affordable in some cases. In others, however, the savings can be far more profound.

Basic Principles

As is so true with many planning strategies, the earlier you can put things in motion, the more significant the potential benefits. Just like any other savings strategy, the more time the money is left to percolate and grow, the larger the benefits.  Obviously, this isn’t always possible. But if the problem is simply a lack of knowledge of some of the options available, then that’s an entirely different kettle of fish. If any of today’s or my future offerings resonate with you, your pocketbook and your reality, I encourage you to take the next step, whether that means gathering more information or actually putting one of these ideas into motion.

Planners typically start by looking at the big picture before drilling down into the minutiae and, because no one likes to feel like they’re not fitting in, I will do the same. Before weighing the different ways of funding junior’s liberal arts degree, here are some BIG PICTURE musings I suggest contemplating first.

  • The Early Bird Gets the Educational Worm

As is so true with many planning strategies, the earlier you can put things in motion, the more significant the potential benefits. Just like any other savings strategy, the more time the money is left to percolate and grow, the larger the benefits.  Obviously, this isn’t always possible. But if the problem is simply a lack of knowledge of some of the options available, then that’s an entirely different kettle of fish. If any of today’s or my future offerings resonate with you, your pocketbook and your reality, I encourage you to take the next step, whether that means gathering more information or actually putting one of these ideas into motion.

  • Sometimes Education Can Be a Family Affair

This point ties in nicely with the last one. For many parents, there are far more pressing financial concerns than funding a child’s university education 15 years hence.  Paying the mortgage, maximizing RRSPs, saving for that first home, ensuring they have enough insurance in place to protect the family upon death or disability, paying off their own student debt or simply keeping their own financial head above the water may all take priority over hopefully sending junior to Harvard or trade school someday. That’s where other family members may be able to lend a hand. Many of my grandparent clients are passionate about ensuring that those cute little people that are part of their gene pool are given every opportunity to achieve their educational dreams and career aspirations. While I strongly encourage these grandparents or other family members to first ensure that their own financial nests are well feathered with a large margin of error, if this is not a concern, then they might want to take a more active role in ensuring that young Dick or Jane will be able to afford school when the time comes.

In some cases, grandparents are reluctant to pry into what they see as their children’s financial affairs.  And, in other instances, I have seen parents who are reluctant to talk about these issues with their own parents if money is tight or to accept assistance when offered. In both cases, the ultimate losers might be the grandkids. Accordingly, although I know this isn’t always possible or even desirable, I encourage both parents and grandparents to consider proactively discuss plans for educating that those fingerpainting youngsters who may one day want to become astrophysicists. In fact, feel free to share this article with parents or children as a springboard to making this happen.

  • One Size Doesn’t Fit All

One of my pet financial planning peeves (yes, I know that this makes me sound like a geek) is reading articles that seem to suggest not only that there is one way to skin a cat but telling you which cat to skin first. Admittedly, some suggestions like “get a Will” are hard to contest, but this is not one of those instances. Each family is different, both in terms of their finances, but also in terms of their needs, goals, values, problems and interpersonal dynamics. 

Figure out your own priorities and values and then act accordingly. And, in some cases, this may mean requiring the child to fund their own education in full or part rather than making life too easy for them or sacrificing some of your other financial needs or goals.

Meet the Players

I will eventually devout a separate article to each of 4 different ways of savings for a child’s education but wanted to first introduce you to the entire cast of characters before shining a separate spotlight on each.  Accordingly, the summaries below are not intended to provide you with a complete list of the good, bad and ugly. As a final warning, this article is written based on the assumption that all parties involved are Canadian residents and citizens. If this is not the case, you’ll need to discuss how this affects your potential plans, particularly if someone is a U.S. citizen or resident.

  • Registered Educational Savings Plans (“RESPs”)

A Registered Educational Savings Plan provides 20% government matching on qualified contributions and allows income and gain within the plan to grow tax-free along the way, with the government grant money (“CESG”) and all plan profits / income taxed in the name of the student upon withdrawal if still in school. The original contributions, which were made with after-tax dollars, are tax-free upon withdrawal, while the grants and gains will be taxed as income. There is a lifetime funding limit of $50,000 in contributions per child and the government CESG are capped at $500 per year, but with an extra $500 in catchup grants per year, to a lifetime CESG grant maximum of $7,200.

The government grants and tax-free compounding make this a very enticing option for many families, but yearly funding caps and maximum funding limit per child both get in the way of maximizing the size of RESPs by the time the children finish high school, which can be of concern if the student has Ivy League potential or has plans to be in school for a long, long time. Accordingly, in some cases, the RESP may be part of the solution but not a complete answer to the question. Moreover, if the child doesn’t use up all of the taxable money, it may need to be taxed in the hands of the parents, with an extra 20% added on, but up to $50,000 can be rolled into an RRSP if the funding parent has enough leftover room, although that parent won’t get the normal tax deduction associated generated by RRSP contributions when taking advantage of this option.

  • In Trust For Accounts (“ITF Accounts”)

ITF accounts are considered as informal trusts, which means that they don’t have the written trust deed, contingency planning and specifications that go with a formal trust, but they also avoid the resulting setup and ongoing administration costs. There is no limit on how much can go into these accounts, nor when. As well, all capital gains earned in this account will always be taxed in the child’s hands at the child’s rate, but any income (think interest or dividends) will be taxed in the contributor’s hands while the child is under 18, unless the money in the account came from an inheritance left for that child or the Canada Child Tax Benefit, in which case the income would be taxed in the child’s name.

Although taxation is not deferred in ITF accounts, if the youngster is not a child model or the proud owner of a very lucrative paper route (assuming those still exist), there would likely be no or a minimal tax hit on all income taxed in the child’s hands.. Because dividends are far more tax efficient than interest income, which is how RESP taxable withdrawals are essentially classified, there may be less of a tax hit and more tax flexibility over these funds after the child is 18. Moreover, there is no restriction on how the money is used, so if the child wants to be a student of life rather than a podiatrist, there aren’t the same potential tax problems faced when a RESP is set up in that child’s name.

On the other hand, there are some significant potential problems with all that flexibility I just discussed. In fact, as soon as the child reaches the age of majority in their province of residence, they have the legal right to demand the money and do what they want with it. Just like for most formal trusts, once the money is contributed to an ITF account, it is no longer owned by the gifter. Accordingly, if the child wants to spend all of the carefully accumulated cash on a fast car, designer clothes and a trip to Maui, then that child might be off to the mall.

On another note, if the ITF account wasn’t funded with the previously mentioned inheritance or Canadian Child Tax Benefit dollars, then any dividends or interest will be taxed in mom and dad’s name at their rates until the year the child turns 18. As a result, if the funder is in a higher tax bracket, the money will not compound nearly as much as within an RESP. Although many of us love, love, love eligible dividends, for people in the highest tax bracket, we could still be looking at over 40% taxation in some provinces.

Finally, if anything happens to the child or the person in charge of the account, there could be a mess. As the funds belong to the child, it will become part of the child’s estate, which could mean the wrong person eventually inheriting. If something happened to the person managing the money, then that person’s executor would take over management of the ITF account, which may not be ideal, unless perhaps the deceased’s Will specified who would be handed the reigns. 

Ultimately, these accounts can work well when the stars align but you will need to ask yourself whether you inhabit such a world or, at least, what you can do to minimize risk. Ultimately, I  suggest investigating other options when larger sums are involved or the youngster in question has a habit of playing with matches, playing online poker or buying $500 jeans with rips in them.

  • Formal Trusts

As also a practicing Wills and Estates lawyer, I admit to having trusts on the brain. But hear me out. In this instance, there are a couple ways that trusts can go a long way towards paying for a few university degrees or trade certifications.

Put simply, a trust a separate entity for tax purposes set up with specific assets and instructions, particularly how the assets are to be distributed. Many trusts are set up to allow the person administering the trust (the “trustee”) maximum discretion as to who gets what.  If done correctly, the income and gains from the trust investments can be taxed in the hands of the recipients (the “beneficiaries”) rather than the original owner. And if the beneficiaries are earning no or minimal income, the tax savings over time can be massive.

  1. Trusts Created and Funded by Living People

The trusts I draft for parents trying to pay for their children’s current or future educations require mom and dad (or whoever else sets up the trust) to loan the money to be invested inside the trust at a minimum government rate (currently 1%) that is fixed for the life of the loan. Without these low-interest loans, income would be attributed back to the contributor while the child was under 18 just like for most ITF accounts. With the required loan in place, mom and dad, can allocate income and gains earned in the trust to their progeny or other family members with impunity.

If the child is already incurring significant expenses, the trust can essentially repay mom and dad for covering these expenses on behalf of the wee ones or pay those costs directly. If there is excess income or gains, the trust could instead pay these amounts to the parents to be taxed in their names or essentially write the kid an interest-free IOU or Promissory Note and leave the money in the trust to compound. Down the road, such as when the child starts university, these IOUs can be paid out tax-free to the child to cover education costs.

Besides set up and annual costs, one of the biggest concerns if what happens if the child goes off the rails. If all of the annual income has been paid out to cover ongoing expenses, then the child has no right to demand anything else from the trust. On the other hand, just like for an ITF account, the child can demand repayment of any Promissory Notes owing when an adult without restriction. Similarly, if the child died prior to cashing in the Promissory Notes, they would become part of the child’s estate, which might see the money eventually end up in an unintended place. Accordingly, it may be a good idea for the child to write a Will or have a Power of Attorney in place when the amounts start to get significant.

I’ll have a lot more to say on this type of trust in a separate article, but I hope this teaser is enough to give you an idea of the potential benefits. And it’s not only mom and dad who might end up loaning money to the trust – grandma and grandpa might be the ones loaning the cash, which might help them keep more of their OAS pensions by reducing the amount of income that might otherwise be reported in their hands, or allow them to drawn down their RRIFs if worried about a big tax bill at death. And, if grandma and grandpa are setting up this type of trust, they might add additional beneficiaries, such as both children and grandchildren, while also stipulating how the money gets divided at their death.

  1. Trusts Created in Wills

Grandparents hoping to help fund a child’s education if no longer around may set up trusts in their Will to make this happen. For smaller amounts, it isn’t usually feasible, but for larger amounts or if creating a single trust for multiple grandchildren, this might be a very tax efficient way of educating the young.  And, unlike the trusts mentioned in the previous section, there is no 1% loan requirement so 100% of the net income can be allocated to the grandkids.

In addition,  I am helping grandparents fund their grandchildren’s education in another way by setting up Wills where they leave their children their inheritances in trusts rather than in cash. These trusts allow the children to control what happens to the inheritance but also names their own children (i.e., the grandkids)  as discretionary beneficiaries for income splitting purposes. As a result, the child can make their inheritance go further by allocating income and gains to their own children so it is taxed at child’s rates.  That parent could control the capital of the trust and could prevent too much money from getting into the grandchild’s hands too soon by only paying out enough income to cover expenses if the trust was drafted to be flexible, unlike an ITF. On the other hand, the trust could instead provide specific instructions regarding funding the grandchild or grandchildren’s education if grandma and grandpa wanted to make sure that their children abide by their wishes.

As a final benefit, the trust could stipulate that the grandchildren inherited whatever was left down the road when their parent also benefiting from the trust died. By contrast, if that parent had inherited directly, (s)he would typically leave the remainder to their spouse instead, which can lead to many unintended circumstances, particularly if that surviving spouse is a poor money manager, remarries or has other children. Needless to say, many grandparents aren’t too keen on those alternative outcomes.

Again, there is a lot more to be said on the subjects of trusts. This article is merely intended to whet your appetite and to seek out additional information from your legal advisor if this option sounds intriguing.

  • Permanent Life Insurance on Children

Buying life insurance on the young is simply too ghoulish for some and I understand that completely. On the other hand, there are many practical reasons for buying policies on children or grandchildren that you may wish to explore. For example, permanent life insurance can be a very tax efficient long-term savings vehicle. Certain policies allow additional contributions that compound more or less tax-free, and the policies can be transferred to adult children or grandchildren without triggering tax so that any withdrawals (such as when the child decides to go to grad school and the RESP is now only an empty husk) can be taxed in the child’s hands. Moreover, unlike ITF accounts, the policies still belong to mom and dad until they officially roll the policies over to the children, which may provide far more peace of mind that setting up an ITF account shortly after a child’s birth and rolling the dice on the child’s future good behaviour.

Just as for the other introductions, there numerous other details to discuss, but let’s leave that for another day.

Conclusion

Paying for a child’s education can be daunting task for some and near impossible one for others.  And it’s been getting harder. On the other hand, with the right plan and proper execution, things can at least get a little bit easier. The next articles in this series will both flesh out the details on the options summarized above and also provide suggestions on how to optimize each approach. Next time, I’ll share some strategies to maximize RESPs.

How Wasting Freezes Can Warm Your Children’s Hearts: Advanced Strategies for Lowering Your Final Tax Bill

Previously, I have waxed (hopefully) poetic on the potential tax benefits on the sale of the family business or upon the death of key shareholder in that business or the family holding company by implementing an “estate freeze” many years in advance.  In simple English, an “estate freeze” typically involves reorganizing the share structure of the company so that the older generation swaps their shares that have previously increased in value for fixed value for preferred shares worth the same amount and with the same unrealized tax liability.  As a result of these machinations, unless tax rates change in the future, mom and dad have now capped their final tax bill on their company shares. Accordingly, in some cases, keeping future growth out of mom and dad’s hands may be the difference between the kids having to sell the company or mortgage it up to its eyeballs in order to pay their parents’ final taxes versus the company successfully transitioning to the next generation.

At the same time as mom and dad swap their common growth shares for fixed value preferred shares, a new class of common shares are created and either issued to younger members of the family, or, as is more common, issued to a family trust mom and dad control that lets them decide later who will get these new shares. Thus, the future growth of the company, which will show up as an increase in value to the new common shares, will no longer be taxed in mom and dad’s hands. In addition to potentially saving the company for future generations at the parents’ death, this can also potentially save the family scads of tax dollars if the business is instead sold during mom and dad’s lifetime. By having the future growth taxed in the kids’ hands, the family can now tap into the kids’ separate lifetime capital gains exemption for small business (about $900,000 at this point for most businesses, but $1,000,000 for farmers and fishers) against this growth. For example, a family of 4 could now minimize tax on approximately $3.6 million of growth rather than just mom and dad’s combined $1.8 million. In most provinces, this represents tax savings of easily more than $400,000 for the example just shown.

Unfortunately, by the time some families get around to implementing a freeze, the value of mom and dad’s shares may have already reached stratospheric heights. Thus, although the freeze may still save the family buckets of future tax dollars, unless the family also engages in other planning, that final tax bill on mom and dad’s death or the sale of the company during their lifetime may still be enough to make stoic men swoon and brave women cry.

Today’s article talks about taking an estate freeze to the next level so that it not only caps mom and dad’s future tax bill but actually reduces it. This is what us lawyer types call a “wasting freeze”, a name tax and financial planning professionals like to use to make our jobs sound slightly sexier.  

While a plain old vanilla estate freeze is typically a one-time event, a wasting freeze usually involves yearly steps after the original freeze has been completed in order slowly chip away at mom and dad’s unrealized tax bill. Just like it typically takes years for a company to grow, it usually also takes many years to systematically reduce the value of mom and dad’s shares without paying too much tax along the way.

This gradual process of reducing mom and dad’s future tax liability is accomplished each year at tax time and can often occur without triggering any or minimal extra tax along the way. For example, even though mom and dad are transferring future growth in the company to their kids, they may still want to continue receiving their typical annual income from the company in order to support their hopefully lavish lifestyles. Post-freeze, mom and dad will likely get paid exclusively through company dividends.  If they were getting paid the same way and the same amounts previously, their yearly tax bill won’t change. If they were receiving a mix of salary and dividends previously and want to have the same amount of after-tax money in their pockets, the increased combined corporate and personal tax hit will still be minimal at worst.

Using dividends in a slightly different way than usual makes the magic happen.  Most of us who own shares in public or private companies simply receive our dividend payments from time to time while continuing to own the same number of shares after getting paid. A wasting freeze instead involves the company retracting or the shareholder redeeming some of the newly issued preferred shares in exchange for dividend payments.  It’s a lot like selling the shares back to the company but for tax purposes, the transaction is treated differently than a typical sale. In this scenario, the shareholder unloading these shares is taxed on the money received as dividends rather than capital gains. Even better, the capital gains otherwise payable is ignored. In the end, if mom and dad were receiving exclusively dividend income previously and continue getting the same amount post-freeze, their current tax bill won’t change but their future capital gains tax hit is slowly but surely going down.

This is best explained by way of an example. Assume that mom does an estate freeze and now owns $2 million worth of preferred shares, all of which will be taxed as a capital gain upon her death. She has always received $100,000 in dividends from the company and will continue to do so going forward. Rather than merely receiving annual payments for this sum without surrendering any of her company shares, she now “redeems” $100,000 of her shares each year.  She is taxed on the dividends in the same way as she’s always been taxed and the unrealized gains on the $100,000 of shares no longer in her hands is ignored. As a result, 5 years later, she has redeemed $500,000 worth of preferred shares, now only owns $1.5 million worth of shares and will have lowered her final tax bill by as much as about $130,000 if she lived in British Columbia. And all of this happened without her having to pay any more tax over these 5 years than she would have otherwise.

But, the taxy excitement doesn’t stop there. If you’ve laboured through some of my articles on how companies are taxed and the different type of dividends (available at www.colinsritchie.com) or are a tax geek, you’ll know that all dividends are not created equal. For private companies in Canada, you have your choice of three different types of dividends, all of which are taxed differently. If used strategically, correctly allocating dividends can both accelerate the timeline for reducing mom’s future tax bill and even reduce her tax bill along the way. They are as follows:

  • Small Business / Ineligible Dividends. These are generated either by business income that was taxed at the small business rate of 11% in B.C. or from investment income such as either interest, rent or the taxable 50% of capital gains realized by a company taxed as investment income at really, really high rates, 50.67% in B.C.  (although much of this is refundable to the company if they pay out enough dividends to shareholders.) Because this money was taxed in the company at either a really low tax rate or generates a large tax refund to the company paying those dividends, people receiving these payments get only a small tax credit to apply personally.  If receiving no other income, someone getting $100,000 in non-eligible dividends in B.C. would pay less than $15,500 in tax (i..e, about 15.5%.), factoring in only the personal tax credit and ignoring things like the OAS clawback.
  • Eligible Dividends. These arise from either the portion of active business income that wasn’t taxed at the small business rate (i.e., 27% in B.C. rather than 11%) or from eligible dividends the company received from other companies, including any investment dividends it receives if it owned shares in Canadian publicly traded companies. Because either your company or the company paying investment dividends to your company paid a lot more tax corporately on the money left to pay you dividend, shareholders receiving eligible dividends enjoy a much more generous tax credit personally when receiving these dividends.  If receiving no other income, someone getting $100,000 in eligible dividends in B.C. would pay less than $7,600 in tax (i. e, about 7.6%), factoring in only the personal tax credit and still ignoring the OAS clawback.
  • Capital Dividends.  Capital dividends are tax-free to the receiving shareholder and are the holy grail of the dividend world. They were created as a way to pay tax-free money to incorporated business owners from the non-taxable 50% of any capital gain realized corporately so that they get to put that money into their personal bank accounts just like non-incorporated business owners could. Likewise, because someone personally receiving a life insurance payout on death gets that money tax-free, most of a corporately owned life insurance policy can be paid out of the company as tax-free capital dividends. Thus, someone receiving $100,000 worth of capital dividends still has $100,000 to spend any way they fit rather than having to share some of this with Ottawa.

Strategically allocating the right type of dividends each year to mom turbo charges the benefits of a wasting freeze. Although mom in our example received a fixed $100,000 per year in order to keep her tax bill to a manageable level and perhaps because she didn’t need any additional money, the family had “only” reduced her final tax bill by approximately $130,000 after 5 years or by 25%. If mom was in her 90’s rather than 60’s, the family might consider speeding up the process. On the other hand, because tax rates increase as income increases, at a certain point, it becomes counterproductive to pay mom out any more taxable dividends, as the tax rate on the last dollar paid will eventually exceed the amount of tax mom would have paid on that dollar at death if taxed as a capital gain. Moreover, paying that tax ahead of schedule only makes sense most of the time if paying at a significantly lower rate, as every dollar paid in tax is one less dollar left to grow along the way.

That’s where capital dividends might come in. Assume that the company sells a building or bank shares inside its investment portfolio at a profit, triggering a capital gain. In such years, the company might use some of this tax-free money generated from the sale to retract more of mom’s shares than it normally does, since it won’t impact her current tax situation but can profoundly reduce her bill at death.  Likewise, if there was a life insurance policy inside the company on dad that paid out, the company could then redeem a bunch of mom’s remaining shares in one fell swoop if desired, or even some of the shares she inherits from dad.  Although I could easily write an entire article on using life insurance both as part of a wasting freeze and to also reduce mom’s own tax bill at death if there was also a policy on her life, I’ll leave that for another day. For now, I’ll just say that corporately owned life insurance has some surprising tax advantages if used correctly and  it’s usually worth a second look, no matter your views on the life insurance industry.

Wasting Freezes and Selling the Family Business

As noted earlier, a family can save an enormous pile of money if it is able to tap into several family members’ separate lifetime capital gains exemptions at sale, if the unrealized gain at sale is significantly higher than can be otherwise sheltered under the original shareholder(s)’ exemption. If the freeze is implemented after the value of the original shareholder(s)’ shares are already well above that mark, mom would still be stuck with a large and potentially unnecessary tax bill. Secondly, it may take several years for the new common shares to grow in value, so that the new family members can tap into a significant amount of their capital gains exemption.

A wasting freeze can help with both problems. Imagine a business worth $3 million at the time of the freeze and unrealized gains of the same amount, with mom and dad each owing $1.5 worth of shares.  They hold the new common shares in a trust that names them and their 3 adult children as discretionary beneficiaries. They plan to sell the business in about 5 years and each of the parents typically takes out $100,000 per year in dividend income. Assume that the business is worth $4.5 million at the time of sale. If they took no further steps, only the $1.5 million in future growth in the company can be sheltered using the kids’ capital gains exemptions, with mom and dad facing a combined tax bill on $1 million of gains (approximately $267,500 if at the highest BC tax rate, assuming that the lifetime exemption has increased to $1 million per person by the time of sale ($3 million in total gains minus $2,000,000 of gains sheltered under the lifetime capital gains exemption.)

If mom and dad get wasted (i.e., use a wasting freeze strategy) instead, they will be able to avoid the potential $267,500 tax bill completely. They will have redeemed $1 million of their preferred shares along the way. Each dollar of preferred shares redeemed simultaneously boosts the value of the kids’ common shares. Accordingly, at the time of sale, mom and dad’s shares have decreased by $1 million to $2 million, which they can shelter under their own exemptions, and the value of the kids’ shares has increased by the same $1 million.  Accordingly, the kids would collectively declare $2.5 worth of gains, all of which can be sheltered under their own capital gains exemptions. When the dust settles, the family now keeps an extra $267,500 without having to pay any extra tax along the way to make this happen.

Wasting Freeze and Holdcos

In some cases, it might actually be worth creating a holding company to hold a non-registered portfolio with significant unrealized capital gain both to cap the future gains and in order to use a wasting freeze to whittle away at the future unrealized tax bill produced by of decades of buy and hold investing in blue chip stocks. The existing portfolio can be rolled into the new holdco without triggering any taxes due to another wrinkle in the Income Tax Act, although the shares will still be taxed on their existing gains when eventually sold inside the company. There are a lot of pros and cons to this strategy, plus other options to consider, but if the plan is to keep the portfolio intact for the next generation without having to sell too many RBC shares at your death, this is one potential way of making that happen.

Conclusion

Although an estate freeze can be a wonderful tool for minimizing a family’s taxes and increasing what is left behind for future generations, sometimes it needs a helping hand. By annually redeeming freeze shares after the freeze has come and gone, diligent shareholders can systematically lower their eventual tax bill on their corporate assets at death or sale. Insurable shareholders can even take it one step further by purchasing insurance on themselves that can be used to redeem freeze shares on death by paying out capital dividends (although more so on the first death) to reduce the tax pain eventually faced by their estates. Although these options need to be considered carefully with the help of seasoned number-crunchers, the savings and benefits can be enormous.

Putting The”More” into Mortgage – How to Best Choose, Arrange and Structure Real Estate Loans

Purchasing and funding a home is one of the most significant financial decisions you will likely ever make. Knowing the ins and outs negotiating and selecting mortgage terms can make a profound difference to your financial future. It’s not as sexy as talking about that junior mining stock you purchased that quadrupled in value or how you saved thousands in taxes through clever tax planning (okay, perhaps that’s not so sexy), but locking in the best mortgage for you and your situation, then managing it properly going forward can have as big an impact or more on your future success, if not more. The benefits of making the right decision can compound and unfold for years to come, one mortgage payment at a time.

I’ll try to limit my use of jargon as much as possible but won’t be able to avoid it completely. In penitence, I have also written a separate article that defines most key mortgage terms and their ins and outs on my website that I also consider essential reading. That article will have a lot more to say about things like the benefits of weekly or bi-weekly payments and prepayment privileges and a bunch of other things that people don’t discuss at cocktail parties.

Getting Started

As a first step, I suggest working with a mortgage broker, like my friend Russ Morrison who has helped me prepare this article and regularly assists my clients. It doesn’t cost you anything, you get the expertise of someone who lives and breathes mortgages on a daily basis and working with a professional allows you to canvass the whole mortgage market rather than just one bank or credit union’s stable of products. Even better, it may also help you get better rates, as banks may not always offer you their best deal unless they know that you can get a better deal elsewhere.

Banks’ posted rates may be 2% or more higher than what they will charge you if push comes to shove. Working with a mortgage broker can hopefully get you lenders’ best rates right off the bat. Although rates aren’t the only ingredient in a great mortgage, they will always be a huge slice of the pie. Almost as importantly, a good broker can also walk you through the fine print regarding penalties, explain how your rate would be determined if you do lock in a variable mortgage later and negotiate better terms with your lenders regarding features like prepayment privileges and porting your mortgage.

The bottom line is that the right broker can not only help you get the best rates and help you weigh the cons of fixed vs variable, but (s)he can also help you weigh the non-rate mortgage features offered by different lenders, as not all mortgages are created equal. In some cases, it may actually save you a lot more money later to go with a lender whose rate may be slightly higher than a competitor offering a similar product if the extra perks of the higher rate mortgage pay for themselves should you want to break your mortgage later or pay it down faster. That is some of the stuff I discuss more in my separate article on mortgage terms.

Big Picture Stuff

Setting up your mortgage is not just about shopping around for the best rate. In some ways, setting up a mortgage is like setting up a proper investment portfolio – balancing risk and reward while also hopefully building in some protection if life goes haywire. Here are some of the things to keep in mind when deciding on the size and type of mortgage that is right for you:

Can You Afford It? Will You Still be able to Afford it Five Years from Now? Just because you qualify for a high mortgage doesn’t mean that you should borrow as much as the bank will give you. Or, even if you can, will it put too much of a cramp in your lifestyle and too much worry into your Sunday nights? Will taking out that big mortgage chain you to a job or career that makes you feel like a wage slave or mean that you only have time to see family and friends on major holidays? Are you planning a family and, if so, do you or your partner want to stay home, or work reduced hours as a result? How would things look if interest rates were 2% higher when it was time to renew? How old will you be when you pay it off and is this after the time you’ve hoped to retire? Are you still able to invest and save for your future? Do you have enough savings or financial backing behind you if you lost your job, got sick or had huge, unexpected expenses?

For better or worse, the mortgage “stress test rules” imposed by the government-linked Office of the Superintendent of Financial Institutions (“”OFSI”) do some of that worrying for us. These rules require that our finances allow us to qualify for a mortgage that is commonly 2% or more higher than the rate we’re actually paying. This applies even for borrowers looking at longer term fixed rate mortgages that won’t fluctuate prior to renewal! Although these rules may protect some potential borrowers from getting in over the heads (and prevent others from buying the home they can actually afford), don’t rely on the government to do your worrying for you. Take an honest, realistic look at your current situation and future plans, crunch some numbers and then borrow only the amount that makes sense to you.

How much certainty do you need? If finances are going to be tight, look long and hard at a fixed rate 5-year (or longer) mortgage, particularly when rates are already low. According financial guru (a Finance Professor at the Schulich School of Business) Moshe Milevsky’s 2001 study, variable mortgage rates beat 5-year fixed rates between 70% to 90% of the time. Other experts more recently echo this conclusion. Although you may win far more than you lose going with a variable mortgage, if you lose on a variable, you might lose big. In the end, even if you may ultimately have done better using a variable mortgage, taking on a 5-year fixed mortgage means taking a bunch of risk off of the table for half a decade and might have also increased the quality of your sleep along the way. If you do go with a variable mortgage, plan ahead to see what your payments would be like if rates do rise to ensure that you can afford to take that risk. Just as importantly, confirm how your rates will be calculated if you do switch into a fixed-rate mortgage at a later date. Some lenders offer far more generous rates than others. If your leading lender contender is on the parsimonious side, it might be worth a second look at some of their competitors. As noted in the next bullet, when making this decision, it’s important to factor in the likelihood of breaking this new mortgage before it comes due and consider the potential penalties you’ll have to pay at that time – the potential costs of breaking a fixed rate mortgage may be many times higher than paying down a variable rate mortgage if rates have gone down. Admittedly, at the time of writing this article, it’s hard to see rates going significantly lower than they are at present.

• How Set Are You in Your Ways? If there is a reasonable chance of you moving within the next 5 years, that might have a big impact on your mortgage decision. As many have found out the hard way, if rates have fallen, fixed rate mortgages can carry a far heftier penalty than their variable friends. Read my last article if you want to know more. In this situation, unless you can’t see rates going any lower, take a second look at a variable mortgage. You might also look at selecting a shorter-term mortgage if you do have your heart set on fixed rates, as the interest rate differential (“IRD”) penalty is based on the remaining term of your mortgage. Thus, the less time left on your current mortgage when you are looking at moving, the smaller the potential IRD penalty. As I’ll talk about in a later article, you would also want to have a “portable” mortgage and rather expansive prepayment privileges so you can either take your mortgage with you from your old home to your new abode or so you can hopefully pay down as much of your current mortgage as possible before breaking it in order to reduce the penalty. A final option, particularly if you’re likely to move sooner rather than later, is taking out a big line of credit or an “all-in-one” mortgage to avoid potential penalties completely. Although you might pay more interest, it could still be worthwhile if the potential penalty would be even higher than the interest you’d pay over the short-term.

Is your Total Debt Load Structured as Efficiently and Effectively as Possible? Many of us with mortgages also carry other debts, 0% car loans aside, that are at higher interest rates, whether it’s unsecured lines of credit, credit card balances, amounts owing on a margin account and more typical car financing payments. (As an aside, when looking at those 0% car financing deals, be sure to ask how paying up front would reduce the purchase price – often, dealers fund the 0% rates by not offering buyers purchasing on credit the same prices they’d offer someone paying cash or borrowing from other sources. If so in your case, this spread represents the hidden interest you’ll be paying on your so-called interest rate loan, none of which is potentially tax deductible.)

When looking at taking out a mortgage, consider whether it makes sense to roll all of those high-interest debts into a lower rate mortgage. Although you’ll still owe the same total amount, you’ll often be paying less over time and will have simplified your debt payments. If some of these other loans are interest-only, you’ll need to keep in mind that rolling them into a mortgage will mean paying back some principal each month and make sure that the cash flow calculations still work. You might also want to look at ensuring that you have a secured line of credit that goes with your new mortgage so you have some wiggle room if you need to borrow additional funds along the way.

What if some of this pre-existing debt is tax deductible, you ask? Many lenders allow you to separate deductible and non-deductible debts into separate mortgage. You may even be able to have different amortization periods for the deductible and non-deductible portions, with a shorter amortization period on the non-deductible debt so that more of your money goes towards debt that doesn’t save you taxes along the way. You can also direct any prepayments you make during the life of your mortgage exclusively towards the non-deductible debt! If you don’t separate out the deductible and non-deductible debt, each payment is applied proportionately against the debt you can and can’t write off. Put another way, if you owe $100,000 and $60,000 of that is deductible, every $10,000 you pay against your debt reduces your deductible debt by $6,000 and your non-deductible debt by $4,000. If you were able to separate out these debts and prioritize paying down the non-deductible debt first, you’ll likely save a lot more over time. In fact, in some cases, you might even consider an all-in-one mortgage where you can pay interest only on the deductible debt until you’ve either obliterated the non-deductible portion or reduced it to a small percentage of the total amount owing.

For those of us with non-registered investment portfolios who are shopping for mortgages, consider whether it makes sense to cash them in and put that towards your mortgage. You will need to take into account any capital gains tax bills that might arise from selling your existing portfolio (although if you’re worried about capital gains inclusion rates increasing anyway, this might be something to consider doing anyway for that reason alone.) Want to stay invested? You can take out a separate mortgage for the amount you want to invest and then put that back into the mortgage. When the dust settles, your mortgage will likely be about the same size as if you left your stocks well enough alone, but now you get to write off the interest on the investment loan mortgage. You may need to work carefully with your real estate lawyer to ensure that you create a clear paper trail showing the investment mortgage money going from the lender to your investment portfolio, preferably without it mixing with any of your other funds. If considering this, I suggest working with a financial professional to weigh the pros and cons and to ensure that you do things right. Finally, if it’s too complicated to take out a separate investment mortgage or if you don’t want to pay any principal on it right now, consider qualifying for a HELOC (“Home Equity Line of Credit”) instead and using this account to buy back your investments. You will likely be paying at a higher rate than if it was part of a mortgage, but you will still have created an interest write-off each year. Borrowing on a margin account instead? Compare the different interest rates and consider using your HELOC to pay down your margin account balance if the HELOC rate is cheaper.

Are you Better off With Different Mortgages: It’s Okay to Hedge Your Bets. Since it’s possible in many cases to chunk your mortgage into different portions, this can open up a lot of different possibilities. We’ve talked about sequestering deductible and non-deductible debt and having shorter amortization periods for the non-deductible portion. That’s not the only way to successfully split your mortgage into multiple chunks. Not sure if you want fixed or variable? You can instead have a bit of both so you can benefit from lower variable rates but still have some protection if rates increase before your mortgage renews.

Likewise, if you might pay down a bunch more of your mortgage along the way than allowed penalty-free, you might have a separate portion as variable to minimize those penalties if you decide to do that, but taking a fixed rate on the portion of the mortgage that you plan on carrying until renewal. Although it still means a potential penalty, it provides maximum flexibility in case you decide not to pay down any extra part of the mortgage along the way and don’t want the hassle of having to renew your mortgage within the next few years, or committing to higher payments each month that go with a shorter amortization period.

You might also want to have different terms for different portions of your mortgage. example, you might want to protection of a 5 year fixed-term mortgage for most of your mortgage, but are expecting a sizeable chunk of money in the next year or so that you’d like to apply to debt. Having a shorter term for a similar amount of your mortgage, whether fixed or term, means that you can pay down that part of your mortgage in full when the cash comes in without having to worry about any prepayment penalties.

Can You Build More Flexibility into Your Regular Payments? In addition to picking longer amortization periods for deductible debt and shorter ones for debt you can’t write off, borrowers who want to build more wiggle room into their monthly budget but can currently afford payments based on a shorter amortization period can have the best of both worlds. If that is you, consider having your mortgage based on a longer amortization period than you actually intend but using the prepayment privileges in your mortgage that allow you to increase your regular payments penalty-free asap so you’re actually on track to pay down your mortgage according to your true target. If your cash flow tightens in the future or interest rates on your variable rate mortgage increases, you can reduce the extra payments without penalty or having to renegotiate your mortgage.

Conclusion

When looking at mortgages, think iceburgs – there is a lot more hidden under the surface than you might see at first glance. The goal of this article is to help you see the full picture so you determine how a mortgage best fits into your overall financial picture and some of the ways you can cut off some edges and round some corners to make it fit even better.