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What to Do If Your Kids Are Not Too Cool for School Part Four: Building a Trusting Relationship

For everyone really serious about educational funding with the money to justify the expense and hassle, you really need to read this article. And that’s not just because one of the ways I pay for my fancy shirt habit is through drafting trusts and Wills.  Today’s offering will take you on a guided tour of all things trust – the good, the bad and the ugly – so you can decide whether setting up a trust now or through your Will to help future generations become everything from lawyers to landscapers, and all things in between.

Trust Basics

In a nutshell, a trust is a legal relationship that features three (or sometimes four) different roles. Although the terms of a trust do not theoretically need to be in writing, they are almost always lengthy documents designed to intimidate the unwary that spell out the parties’ different obligations and rights, include safeguards to protect the parties, and cover off what happens in a variety of different situations. The cast of characters are:

  • Settlors: The person(s) who establish and make contributions (as opposed to loans) to the trust. If the trust is established in a Will, the Settlor has played a key role in determining the terms of the trust and funding it. In most of the other situations where the trust is set up for educational funding, the settlor is often a figurehead following the instructions of one or more of the trustees, and the contribution is merely a ceremonial one of something like a silver coin. The bulk of the trust assets under this scenario actually come from loans at the minimum required rate from some of the trustees or perhaps other relatives, such as a grandparent looking to piggyback on a trust set up by one of their child.
  • Trustees: The people running the trust according to the terms specified in the trust deed. The deed may provide precise instructions how much can be paid out or the type of expenses that are covered or may essentially allow the trustees to do whatever they want, including even paying money out to themselves.
  • Beneficiaries: These are the people who, well, benefit from the trust. They are the ones that get paid or have their expenses covered by the trust. In most cases, they have to declare and pay tax on their distributions from the trust as if they’d received any income, dividends or capital gains directly rather than through the trust.
  • Protectors / Appointers: A person with the power to replace or fire trustees and perhaps investigate how the trustees are doing their job, particularly if a beneficiary raises a concern. This role isn’t included in all trusts, in which case successor trustees are named instead and / or the trustees are given the power to pick their own replacements.

And, if this isn’t confusing enough, it is possible that the same person may play more than one role, depending on the circumstances. For example, a trustee may also be a beneficiary in some instances and perhaps also the protector. Typically, for educational trusts, the settlor does not moonlight in any of the other roles and cannot if the trust is funded by a substantial cash gift rather than just a silver coin.

The Main Benefits of a Trust

Trusts can be set up for many reasons, but when talking about educational fund, the key benefits are typically tax savings and flexibility. On the other hand, those aren’t the only reasons. A grandparent may decide to set up and fund a trust prior to death for estate planning purposes in order to actually see the benefits of this generosity, while another octogenarian may set up a trust in their Will as a way to guarantee the money will be there for the youngster’s education rather than gifting it to parents who might have their own financial issues or might be tempted to use the money for other purposes. I’ll say a bit more about the main two benefits of setting up a trust below.

Flexibility

One of the reasons I like trusts are because they are not like off the rack suits where the shoulders might be a little baggy or the pants just a little too long – they can be custom-fit to accommodate the specifics of a multitude of situations and desires. It can be a single trust created for an entire pool of grandchildren or each can have their own. It might even be possible to have subaccounts for each grandchild within a single trust in order to get the best of both worlds – reduced administrative costs but separation of each child’s entitlement. The trust’s distribution instructions can be as rigid or as flexible as desired and might provide a windup date, such as when the youngest child graduates, turns a certain age or has been out of school for a set period of time, or may be open-ended, so that the family can continue to income split income with the children for as long as it makes sense. And, in these days of soaring housing prices, the trust might actually have a secondary purpose of accumulating money as tax efficiently as possible so that the children may actually be able to afford a home one day that is within a two hours’ drive of their big city parents.

Just as importantly, a good trust can include a level of contingency planning that isn’t possible with the other educational options I’ve discussed in earlier articles, such as covering off what happens to the money if the child doesn’t go to school, passes away unexpectedly or turns out to be a serial killer. In particular, fully discretionary trusts would likely include other beneficiaries, including sometimes people loaning (but not gifting) money to the trust in order to minimize the chances of having to give large chunks of money to youngsters with no control as to how it is spent.

Finally, when a trust is funded is flexible. People funding RESPs are incentivized through the grant rules to dribble in money rather than get as much money working and compounding as soon as possible. For trusts that are funded by loans, there is no limit on how much money can be contributed or lent when the trust is created. It is also possible to lend and potentially gift more money to the trust if someone gets a big bonus or has a lot of luck playing scratch and win, depending on the circumstances.

Tax Savings

Although the tax savings may be largely an afterthought in some instances, it is often the primary reason for wading through this quagmire of law and tax. The specific tax savings will depend on how the trust was funded and whether it was through a Will or while the settlor was still around to complain about the government full-time. When a trust earns income or gains, it has two options – either pay the tax on the trust’s own tax return or allocate the money to one of the trust’s beneficiaries, who gets stuck with the tax bill instead. The tax savings arises when the youngsters getting the money are in significantly lower tax brackets than the person who contributed or lent the money to the trust. In B.C., that can be the difference between paying tax at 53.5% on interest income vs. no tax at all if the beneficiary isn’t earning other income or has a lot of tax credits to use up.  When the size of each year’s income and gains is large enough, the annual tax savings when compounded over decades can be a game changer.

Grandparents may also use these trusts to minimize their final tax bill since assets in the trust and the unrealized capital gains aren’t taxable at their death. The trust acts like a Will in many ways and can stipulate where the money goes at that time or whether it remains in trust if the grandkids still having some learning to do. It can mean triggering some tax if it is necessary to sell assets or transfer them in kind to the trust, but this can be a small price to pay in many cases in the grand scheme of things. As an added bonus, since the trust assets aren’t part of the estate, they won’t be subject to probate fees, nor exposed to Will challenges, although any loans to the trust may still be fair game, although there may be other ways to tackle those problems if necessary.

There are a few other important tax rules and requirements that I’ll spell out here:

Don’t Pay Tax Inside the Trust

Income or gains taxed in the trust are taxed at the highest personal tax rate for that province’s residence (usually determined by where the trustees live.) Accordingly, it usually makes sense to flow out all income and gains net of deductions to the beneficiaries each year so that the money is taxed at their rates. On the other hand, for minor beneficiaries, trustees are usually limited to paying out enough money to cover the expenses incurred by their parents or covering expenses like private school tuition directly.

Fortunately, there are several options if the children’s expenses aren’t large enough to absorb every last taxable dollar. First, the money can always go to other beneficiaries, which may include the parents in some cases, even if that means paying tax at a higher rate than the kids, if that is still at a significantly lower rate than the trust’s. In some families, planning on paying taxable distributions to the low-income spouse might be one of the reasons for setting the trust up in the first place, with the kids only getting enough to reimburse mom and dad for the children’s expenses. Have other lower income relatives that might need a helping hand, such as parents? Including them as discretionary beneficiaries can be a far more tax efficient way of putting money in their hands  rather than gifting them after-tax dollars.

As a second option, trustees who don’t have any lower income relatives, can simply write interest-free Promissory Notes to the children for any amount that exceeds the child’s annual expenses. This corresponding amount is still taxed in the that kid’s hands but the money can actually remain inside the trust to keep compounding. Those notes are legal obligations, and the children have a legal right to ask for the money without restriction as soon as they are adults, so it’s important to be careful when considering this option. It’s possible to pay these notes down over time ahead of a boy becoming a man if mom and dad start losing sleep at night over junior’s prospect by using the Notes to pay expenses and allocating future years’ taxable distributions to other beneficiaries. And, if the child has Ivy League dreams, past years’ Promissory Notes can be essentially a way of prepaying costs if expenses are in excess of what the trust can reasonably generate in income each year. When talking Harvard, it might not be too hard to burn through several years’ past years’ worth of Promissory Notes in one fell swoop.

Finally, it’s possible separate the taxable and non-taxable portion of capital gains and allocate out only the taxable portion to the kids, keeping the rest inside the trust or paid to a beneficiary in a higher tax bracket, perhaps to help pay down a mortgage without having to draw extra money from a company at a high personal tax rate. In other words, if the trust had a $50,000 capital gain after subtracting realized capital losses, it would only have to allocate out $25,000 in order to avoid paying any tax on the gain inside the trust. The other $25,000 could be allocated tax-free to another beneficiary, used to pay down any loans or allowed to continue growing and earning money inside the trust.

              It May Be Better to Loan that Gift

Our government has a series of measures called the “attribution rules” that are designed to prevent relatives gifting money to mostly spouses and minors in order to save on future taxes. These rules attribute the gains and income back to the gifter in many cases, which can undermine the purpose behind the generosity in many cases. On the other hand, there are exceptions to these rules. In particular, if the money is loaned to the person in question at the minimum prevailing government rate that is in place at that time (the “prescribed rate”), then the rules don’t apply, provided that the lender is actually paid the interest by January 30 of the next year and that it’s declared on the lender’s tax return. Don’t miss a year, as that can mean losing the right to use this strategy forever. On the bright side, although it means the high income lender has to pay tax on some interest at a high rate, the borrower can at least deduct the interest paid as an investment expense.

At this point, the minimum rate is 1% per year, which is locked in forever for existing loans. Unfortunately, rates rise only in whole numbers and are dependent on a complicated government formula that looks at 90-day t-bills in the first month of the previous quarter, so that the rates on new loans are adjusted 4 times per year. In light of the rapid increase in rates, the July 1, 2022 rate will increase to 2% per year, which is still great in the grand scheme of things for many families, but is still twice what is currently required. Accordingly, families with existing trusts or who are sitting on the fence need to make either additional or their initial loans prior to then to maximize their future savings. The same holds true to families where one spouse might want to loan money to a lower income spouse without bothering with a trust.

There is another important reason why the loan option may be preferable to gifting: flexibility. If lent rather than gifted, the money contributed to the trust can be called in at any point should the lender need the money for other purposes or decide that the beneficiaries would not longer need, benefit or deserve any financial assistance. And, if parents are setting it up, the plan may simply be to save money on the income and gains generated on the trust investments while the children need educational assistance or getting a start in life rather gifting them the capital needed to generate the income or gains.  Although any remainder left after the lenders are repaid their loans still needs to be paid out, even this can be allocated back to the original lenders if they are beneficiaries of the trust. Accordingly, although the money can always go towards the children if appropriate at windup, it’s usually better for this to be something that be figured out then something that has to happen, come hell or highwater.

If the money is gifted rather than lent, the gifter is typically the settlor of the trust and is not allowed to get the money back and wouldn’t be a beneficiary of the trust. Although their spouse might be a beneficiary, the dreaded attribution rules would still apply and put a huge crimp in any plans of having gains and income taxed in that lower income spouse’s hands. Accordingly, the gifting option is often reserved for grandparents either during life or in their Wills, when they know they won’t need the money back and can allocate income, gains and gifts of capital out of the trust to multiple generations, so their own children can ultimately get the capital if the grandchildren aren’t ready or deserving of the responsibility of receiving a lot of money without any strings attached.

              Diarize the Date – Year 21 Can Be an Expensive One

In some instances, Year 21 for most trusts can be like the clock striking midnight at Cinderella’s ball – the end of the magic.  For the types of trusts I’m discussing, there is a deemed disposition or sale of all trust assets inside the trust on each 21st anniversary. On the other hand, this may not always be so bad as it might first appear.

First, at any time prior to that date, trust assets can be distributed without triggering tax to a beneficiary, who inherits the same unrealized capital gains on the assets, which would only be triggered when the beneficiary sells or dies. Accordingly, provided that there is a beneficiary that you’d trust to inherit the assets, then there is no big tax bill to worry about, plus many years of  prior potential tax savings and perhaps more if the beneficiary receiving those RBC shares is in a lower tax bracket or has no plans to sell until they are.

Secondly, the trust may have been regularly realizing gains along the way so that the 21st anniversary is a non-event, although they may still wish to celebrate if the mood strikes them. And, if there are still a few stocks with huge gains or perhaps a piece of real estate, then perhaps only those assets get distributed out rather than the entire kit and kaboodle.  For some trusts, I even regularly suggest triggering gains every few years anyway in order to avoid year 21 problems if there are low-income beneficiaries and to provide more flexibility down the road for later years if the beneficiaries are no longer in lower brackets.

Thirdly, if there are a lot of beneficiaries and the gains can be spread into many hands, then the collective tax pain may be far less, well, painful, than if the gain was either taxed in the trust at the highest rate or at similar rates in the beneficiaries’ hands. Again, it’s important to remember that only 50% of the total gain is ultimately taxed. Thus, a $500,000 unrealized gain means that only $250,000 in taxable income needs to be allocated to beneficiaries. And, if there are enough in lower tax brackets, then the tax hit is not a devastating one, particularly if those beneficiaries can use the money to make a large RRSP contribution if the trust distribution would otherwise put them in a much higher rate than usual.

Finally, life insurance owned inside the trust isn’t subject to the 21-year rule, although the policies can still be rolled out to beneficiaries tax-free at any point. Accordingly, trusts with big cash value life insurance policies can skate through the 21st anniversary with impunity, with the cash values continuing to grow. Owning life policies inside the trust can be done primarily for investment purposes, perhaps with the eventual idea of rolling out policies on the kids to them to eventually own directly when they are hopefully wiser rather than just older. For families looking to ensure multi-generational wealth, the policies can also be a wonderful way of refilling the family coffers for the grandchildren on their parents’ death in the event. Anyway, I digress and will talk more about this in my next and hopefully last article in this series.

Trust Do’s and Do Not’s

Assuming you’ve made it this far down the trust rabbit hole and are still intrigued, here is a list of trust do’s and do not’s:

  • Keep records, particularly of the children’s expenses and any direct payments made to others on a beneficiary’s behalf.
  • Prepare annual trust resolutions documenting who gets allocated what and prepare promissory notes if trust funds are to be retained inside the trust to continue growing rather than distributed to a beneficiary, their guardian or paid to them directly. Draft these records in the anticipation that someone else with no knowledge of the trust’s history may have to piece this together someday.
  • Be sure to pay any interest on loans by January 30th of the next year and have the lender declare this on their tax return.  One missed year may be enough to cause the entire house of cards to come tumbling down.
  • Have a broad list of beneficiaries or ensure that beneficiaries can be added later to increase the flexibility and tax savings. For example, a trust set up to fund your children’s education may ultimately also be used to fund your grandchildren’s as well, or to help other relatives in need, or for estate planning purposes. A long list of beneficiaries, potentially including yourself and your spouse if the trust was funded through loans, removes the obligation to distribute money to a child who has gone off the rails or if others need it more.
  • Be careful not to add US beneficiaries or to get legal advice before doing so, and consider provisions that allow you to remove beneficiaries that move abroad if that is going to cause tax problems.
  • Get advice before adding real estate to a trust because of the 21-year rules and potential property tax when transferring the property to a beneficiary directly to avoid a capital gains tax hit. Furthermore, it can be disastrous when owning real estate located in some parts of Canada (such as the Lower Mainland) if even one of the beneficiaries are neither a Canadian citizen or resident, as that can trigger foreign buyer’s tax at 20% every time a trustee is replaced and in other instances.
  • Invest appropriately for your goals. If the plan is to deliver steady income and gains each year to maximize the income splitting, invest accordingly, rather than swinging for the fences.  And, if the plan is to eventually pay out whatever is left to the kids net of the loans to help them with a first house, as is now also almost a necessity in some cities, invest with this time horizon in mind so that the child isn’t stuck with a studio suite rather than a two-bedroom condo with a hot tub just because it was time to liquidate a high volatility portfolio during a market correction.
  • Manage the trust’s assets with the 21-year rule in the back of your mind so that you aren’t forced to roll out assets or collapse the trust at that time merely for tax reasons as discussed earlier.
  • Get an estimate of the costs, both for set up and the ongoing costs before taking the plunge. Talk to someone else with a trust if possible.
  • Loan as much money as possible at 1% prior to July 1, 2022!

Conclusion

Trusts can often be the best way to fund a child’s education and to maximize family wealth building if the amount of money involved justifies the hassle and expense, particularly during the setup year. Although I tried to walk through the good, bad and ugly during this article, you’d still need to talk through the specifics of your situation with your own lawyer and tax advisor, particularly if funding the trust would involve triggering a big tax bill up front or dealing with potential beneficiaries that do not live in Canada or may move abroad.

What to Do If Your Kids Are Not Too Cool for School Part Three: All About In Trust For Accounts

A good education can be invaluable, but it seldom comes for free. In these days of rising housing costs, interest rates and taxes, it is getting harder and harder for some families to help younger family members get that education. In my last article, I devoted a few thousand words to the most common way of funding these pursuits – Registered Educational Savings Plans or “RESPs”.   Today’s missive focuses on another way to help fund an education, even for families that have already maxed out RESPs: In-Trust for Accounts or “ITF Accounts.”

Despite their benefits, RESPs may not be a one-stop solution, particularly if Junior has Ivy League aspirations or educational pursuits that seem to span decades. For other families, the  numerous rules surrounding RESPs and penalties that can arise if a child doesn’t go to school or use up all of their grants and gains, may cause them to look for a more flexible alternative.

That’s why families look at other educational funding strategies as either an alternative to or in addition to RESPs. ITF Account are one of those choices and, on first blush, there seems like there is a lot to like:  less initial paperwork, no funding limits and more flexibility on the back end should junior wishes to busk rather than earn a baccalaureate. The tax savings while junior is a minor also offer appear to offer tantalizing tax savings – accounts funded through an inheritance, a gift from a foreign relative or by the Canada Child Tax Benefit allow all income and gains to be taxed on the child’s return, although ITF Accounts funded from other sources usually tax income (but not capital gains) in the hands of the contributor while the child is a minor.

Unfortunately, despite the surface appeal, there are some significant drawbacks to ITF Accounts and some practical complications that might get in the way of some of the theoretical tax savings. Read on and decide for yourself whether ITF Accounts are an ingenious solution or a problem just waiting to happen. Before I begin, a quick shoutout to Canadian Moneysaver Magazine reader Claire Scribner for her invaluable questions and comments!

 Basic Principals

From a legal and tax perspective, ITF Accounts are informal trusts, which means that they operate according to the same basic principles of those elaborately detailed written trusts that I’ll talk about in my next article, but without all the structure, details, costs and paperwork that goes along with their more glamorous cousins.  That means that there is someone managing the assets (“the trustee”), on behalf of the person who is entitled to the benefits of the account (the “beneficiary”). Thus, many parents are the trustees of ITFs for which their children are beneficiaries. Theoretically, ITFs should be taxed inside the trust and all income or realized gains not distributed or deemed to be distributed taxed at the highest margin rate for the trustee’s province.

Is It Really AN ITF Account?

As is so often true, however, life is more complicated than it may appear at first glance.  First, it may be debated whether you’ve actually created a trust at all by the CRA since certain legal formalities are required and ITF Accounts rely on solely the account opening documents rather than the lengthy trust documents that go with a formal trust.  It could be that you’ve merely opened a non-registered account earmarked for the child that should be taxed in your name or you’re acting as agent for the child and their babysitting funds rather than as a trustee. If all of this sounds confusing, then you’re not alone. If you want to establish a true ITF account, you’d want to confirm the intention to gift, the items to be gifted and identity of the person entitled to benefit from the largesse. The account opening documents should hopefully clarify the trustee and the beneficiary. Ultimately, this can be a lot to expect from ticking some boxes and filling in a few blanks.

Moreover, the CRA would also look at who has been paying the tax on ITF Accounts. Since ITFs generally don’t apply for a trust number (which is like a SIN number for trusts) and minors cannot establish their own investment accounts, ITFs are typically opened using the trustee’s SIN number.  As a result, all tax slips for the ITF will also be issued in the trustee’s name. That means that if the trustee doesn’t report the income and gains on their own tax return, the CRA automatically picks up on that and starts sending out nasty reassessment notices.  Although an accountant friend of mine advises that it may be possible to then go back and forth with the CRA about this every year, the hassle factor and potential accounting costs if someone else is doing this may not be worth it, particularly if the ITF is not a large account and / or the income would have otherwise been taxed in the adult’s hands anyway (such as if a parent funded the ITF).  As a result, despite the best of intentions, if the trustee has been paying tax on the income and gains, that might be enough for CRA to deny that a true ITF had been created.

In some cases, in fact, this denial may be a blessing in disguise. If the account is treated like a trust and none of the income or gains have been paid out of the trust or promissory notes for these amounts payable to the child issued, the CRA can argue that the income and gains should be taxed in as trust, which means at the highest marginal rate inr the trustee’s province of residence. In other words, the ITF account might become a tax albatross rather than a tax saver.

For those willing to go the extra mile and fight this battle, such as when many years of tax savings still lie ahead and you think you’ll be able to tax even income in the child’s hands, I suggest that the trustee treats the ITF like a formal trust, which requires the following:

  • All taxable income or gains should either be taken out of the account and spent on the youngster, or the trustee writes formal promissory notes on behalf of the ITF to the beneficiary for these amounts that are immediately cashable, although mom and dad are still entitled to blithely ignore junior’s demands for the cash until (s)he come of age.   This hopefully prevents the CRA from taxing the income in the trust at that province’s highest marginal tax rate.
  • Document your intentions to create a trust through a separate document when opening the ITF Account and be consistent in stipulating who pays the tax on the income and gains each year.
  • Investigate getting a formal trust number from the CRA and using that number for the ITF’s bank or investment accounts rather than the trustee’s personal SIN number. Expect a lot of questions from those financial institutions and hassle regarding where the money has come from and request for details.
  • Assuming you survive the administrative quagmire of actually opening accounts in the ITF’s name, be prepared to file annual trust tax returns on behalf of the ITF.  The rules and disclosure requirements for trusts are in the process of changing significantly. At this point, the proposed legislation suggests that ITF Accounts worth less than $50,000 owning things like GICs and publicly traded securities may not always have to file tax and information returns, depending on their activity that year, but this may change.
  • If hoping to get all income taxed in junior’s name under one of the previously listed exceptions to the general rule, don’t commingle (a word I try to fit into daily conversation) money qualifying for an exception with money that does not or risk having income taxed in the trustee’s hands.
  • Keep records, records and more records. This means tracking the source of the ITF funds, particularly claiming an exception to the general tax treatment of income, as well of the expenses mom and dad paid on junior’s behalf that the trust is reimbursing.

Some other Potential Benefits of ITF Accounts

Although having capital gains and, perhaps, income taxed in the youngster’s hands can be a wonderful thing, particularly it’s still many years before (s)he’s old enough to buy their first drink, ITF Accounts may provide some other benefits in the right circumstances, including:

  • Protecting assets for the child if the parents get divorced or, perhaps, against creditors, since the money in the ITF no longer belongs to the person funding the account. If it doesn’t legally belong to the trustee and (s)he didn’t fund the account 10 minutes before filing for bankruptcy, ITF Accounts should ultimately live to fund another day.
  • Avoiding Will challenges, taxation, probate fees and unexpected results at the trustee’s death. Although ITF Accounts can have other problems if a trustee dies within money still in a child’s ITF Account, it should still belong to the child beneficiary, regardless of the deceased’s Will.  If the money was just kept in a separate non-registered account in the dead trustee’s name, it would be distributed according to the deceased’s Will.  Accordingly, unless the trustee’s Will specifically says that the non-registered account passes to the child, it would be distributed as part of the residue of the estate where it might pass into unintended hands, could be scooped up by estate creditors or tied up in Will challenge litigation.

Why ITF Accounts Keep Lawyers up at Night

Even if you thrill at the thought of the extra paperwork and never turn down the chance to bicker with the CRA, there are many other reasons why you may wish to give an ITF Account a hard pass. Here are some of those scary contingencies:

  • Loss of flexibility and control. Once the money is gifted, the money belongs to the child. That means that before your child is old enough to drink in the US, they have the absolute right to demand their money and spend it as they wish. Accordingly, if you’re worried if your child has a thing for fast cars and trips to Maui, an ITF Account might be a ticking timebomb. On a related note, the money cannot be used for anyone but the child, no matter what life surprises await. A non-registered account without the tax advantages of an ITF Account allows the parents or grandparents to retain control of the money if the child goes off the deep end or it turns out later that the money would ultimately be better spent on themselves or another family member.
  • Estate complications on the child’s death. If the child dies with money in the ITF Account, it becomes part of that child’s estate. Since most children can’t or don’t have valid Wills, that means that the money will be distributed according to the laws of intestacy in that province. In addition to potentially paying probate fees and expensive court applications in order for someone to manage that estate for the dearly, the money may end up in the wrong hands. For example, how would you feel about your ex-spouse getting 50% of the ITF Account you funded by working overtime and forgoing vacations if your child died without dependants or a spouse?
  • Complications on the trustee’s death. Unless the trustee’s own Will stipulates who manages the ITF account, the task will generally fall to his or her own executor. This person may not be right person for the job, particularly in blended family situations when your new wife ends up managing the account a stepkid.
  • Potential liability for inappropriate investment decisions. Admittedly, this is a stretch, particularly for smaller accounts. All the same, I strongly recommend against a penny-stock heavy strategy, as trust law says that all investment decisions should be reasonable ones depending on the timeline and intention for the account.  

The Bottom Line

While ITF Accounts can play a valuable role in educational funding in the right circumstances, I don’t see them as the best alternative in many others. I am far more comfortable with them in the following circumstances:

  • The child is already close to university age and has already demonstrated that they have their act together. 
  • The person funding the account is okay with the child using the money for other purposes should the child not go to university or have money left over afterwards.
  • The funder has ample other resources should life through them a curveball.
  • The account size isn’t so small that it’s not worth the hassle or complications and not so large that it would be a catastrophe if things went wrong. For larger amounts, a formal trust is a far safer option that cover off what happens if things don’t work out and provides the trustee with far more control, including not requiring a full payout at age 19 or allowing distributions to other beneficiaries in some circumstances, such as a single educational trust for a group of children or grandchildren rather than pinning all of your hopes on a single child / grandchild.
  • The trustee is a details person.
  • Income and capital gains will both be taxed in the child’s hands (or the account is set up to minimize taxable income until the child is an adult) and would otherwise be taxed in the gifter or trustee’s hands at a much higher rate so that there will be enough tax savings to make the risk and hassle worthwhile.

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.