STRATEGY SHEET
February 1999
RESPs Not Always
the Best Strategy
© Talbot Stevens
This month, we continue with the after-tax income comparison of RESPs and the alternatives from January's Strategy Sheet.
The “In Trust For” (ITF) approach discussed earlier can be improved by potentially getting all of the capital gains out tax-free. This is done by selling fund XYZ and buying fund ABC to trigger the capital gains in the child's name before they start post-secondary education when they have little or no income. In the table, this is referred to as “ITF (best)”. “ITF (worst)” is where no triggering of capital gains has been done before school.
We saw in last month's table, that an equity investor with a child 5 years from school would definitely be better off with RESPs.
Investing $2,000 a year averaging 10% returns produced an annual after-tax income for the student of $4,620 for four years. This is almost $800 a year better than the old RESPs without the grants, or the ITF approach. Parents in a 40% tax bracket, who invested in their own name, would produce only $3,440 a year, or 26% less than RESPs.
Notice that the old RESP without grants and both ITF approaches, with and without triggering of gains before school, all produce the same after-tax income. This is because all of the growth is drawn out in the child's name tax-free. This will not always be the case, as illustrated next.
Consider the longest possible saving period to qualify for RESP grants.
Over an 18-year period, $2,000 a year is invested and the child is expected to earn a higher $17,000 a year while a student. This income will consume almost all of what the student can earn tax-free. Again, annual equity returns are expected to average 10%.
| $2,000/yr, 18 yrs, 10% Equities, $17,000 Income | ||
|---|---|---|
| Strategy | 4-yr ATI | %change |
| RESP w. grant | 26,770 | --- |
| Old RESP | 23,310 | -13% |
| ITF (worst) | 26,480 | -1% |
| ITF (best) | 28,640 | +7% |
| Parents (40% tax) | 21,970 | -18% |
Notice that when the student's other income is high, the best ITF approach, with the gains triggered before school, can produce more after-tax income than RESPs and can be used by the child for any purpose, not just an education.
General conclusions. For most students with average or modest incomes, RESPs will generally produce more after-tax income than even the best managed ITF approach.
The downside of paying an extra 20% penalty tax on the RESP growth if the child doesn't go on to school can be totally eliminated by ensuring you have enough RRSP room to transfer all of the growth, not including your contributions.
The ITF approach is still worth considering for the flexibility or if you want to use your RRSP room, especially if the student is going to earn a high income.