January 1999

After-Tax Income of
RESPs and Alternatives

© Talbot Stevens

October's Strategy Sheet introduced how the new government grants of up to $400 a year now make RESPs much more attractive.

As my new analysis has emphasized, after-tax income is all that matters for income-based goals like retirement and education.

Before we automatically jump to the conclusion that the new grant of up to $400 per year makes RESPs the best strategy for saving towards an education, shouldn't we accurately analyze the after-tax income merits of RESPs and the alternatives?

Focusing on after-tax income is especially relevant because the “In Trust For” (ITF) approach of investing for capital gains in the child's name can result in almost all of the withdrawals coming out tax-free. With an RESP, the contributions are recovered tax-free, while all of the growth is taxable as income in the child's name.

Conceptually, it might be possible that the benefit of getting almost all of the ITF funds out tax-free is more valuable than getting a 20% government grant on the first $2,000 of RESP contributions, especially if the student's income is high enough.

The key to comparing after-tax income merits is determining what portion, if any, of the education savings will face tax in the student's name.

In 1998, the average tuition for an undergraduate arts program was $3,200. Beyond the tuition credit and the $7,000 basic tax exemption, a student can also claim an education amount of about $1,200.

These three deductions mean that a student in 1998 could earn $11,400 before paying any income tax.

Tuitions have increased an average of 11% in the Nineties and 6.5% in the Eighties. I have projected annual increases of 7% to determine the tax-free amount a student can earn in the future.

The basic strategies for saving for an education include RESPs, an ITF approach where the parent invests in equity funds “In Trust For” the child, or parents could invest in their own name.

Let's evaluate the after-tax income (ATI) that each strategy can produce in the student's name over a four-year period.

The first case is for a teenager that is 5 years from school. The student will earn a modest $5,000 of other income 5 years from now, not including the investment income. The parents will invest $2,000 a year and expect to get 10% returns in equity funds.

$2,000/yr, 5yrs, 10% Equities, $5,000 Income
Strategy 4-yr ATI %change
RESP w. grant 4,620 ---
Old RESP 3,850 -17%
ITF (worst) 3,850 -17%
ITF (best) 3,850 -17%
Parents (40% tax) 3,440 -26%

Discussion of this, and another case where the ITF approach is better than even RESPs with the new grants, will continue with next month's Strategy Sheet.

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