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.
- 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.
- 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.
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Colin S. Ritchie 