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Second Podcast Episode on Estate Planning Now Available

Common Estate Planning Mistakes

I had the pleasure of being interviewed by my friends Richard and Matt Vetter of the WealthSmart Inc. team the other week and they have just released episode of two. I’m attaching a link to the podcast for those of you who would like a listen.

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.