Friday, March 7, 2008

Changes coming to RESPs?

This week, the House of Commons passed a bill that would provide a tax deduction for RESP contributions. The bill still needs to be approved by the senate, but it's an interesting idea.

Currently, RESP contributions are made with after-tax dollars, and compound tax-free until they are withdrawn by the beneficiary for post-secondary education purposes. At withdrawal, the investment income is taxed to the beneficiary, at their (usually low) marginal rate. Under the proposed bill, up to $5,000 in annual contributions would qualify for a tax deduction, similar to RRSP contributions. This would represent a fundamental change in the tax treatment of these plans, and potentially provide a much greater incentive for parents to contribute to their children's plans.

I've written before about the benefits of contributing to RESPs, essentially looking at this plan as a sort of "education insurance", but this new bill would significantly change some of the assumptions. Let's look at a simple example to determine what the impact of this change might be:


  • One-time RESP contribution of $5,000

  • CESG match of $500

  • Contributor marginal tax rate = 43.41%

  • Beneficiary marginal tax rate = 22.15%

  • Investment growth = 8%

  • Inflation = 3%

  • 18 year investment period
The $5,000 contribution would generate an immediate tax savings of $2,170.50 for the contributor. In future dollars (i.e. after 18 years' inflation at 3%), this would be $3,695.13. The $5,500 (contribution plus CESG match) would grow to $21,978.11 after 18 years of 8% growth. Assuming that the beneficiary withdrew this entire amount for education purposes at the 18 year mark, they would pay $4,868.15 in taxes (since taxes would presumably be paid on both the contribution and the investment income). This represents $1,173.02 in net taxes paid (i.e. taxes paid by the beneficiary minus taxes saved by the contributor).

Compare this with the current rules, where the beneficiary would pay tax only on the $16,478.11 investment income, for a net taxation of $3,649.9 (since the contributor does not have any up-front tax savings). This is $2,476.88 more than the taxes paid under the proposed system.

Based on this example, it seems that the proposed tax deduction would result in a much more tax-efficient way to save for education, especially if the contributor were to put the $2,170.50 tax refund in a TFSA for some additional tax-free growth.

What do you think about this idea? Have I missed anything?


Traciatim said...

"Have I missed anything?"

Only that you can only make a small withdrawal in the first 13 weeks and most people would split the withdrawal over 2 years (like a student loan) so the income would be spread out.

Plus the fact that the tuition paid and the textbook credits would make their income drop so they would pay nowhere near the maximum amount of taxes on the amounts taken out.

Loonies And Sense said...

Proving my point that this would carry a greater tax advantage than the current rules.

Regardless of how long the withdrawal period is, any incremental taxes paid by the beneficiary at withdrawal would be more than offset by the up-front tax savings by the contributor.

Traciatim said...

What happens if someone were working a couple days a week to put themselves through school and paying for their living expenses with their job. Now they are going to be faced with a tax bill come tax time. Sure, it's better than having a loan, but I like the RESPs the way they are now.

Plus, making it a tax advantage skews the benefits to high income families rather than equal for all.

Loonies And Sense said...

Granted, the incremental benefit is greater for contributors in higher tax brackets, but when you look at the total taxes paid by the contributor/beneficiary pair, even low-income families would be better off under the new system.

I guess the real downside of this is not so much with respect to taxes, but rather the effect this would have on the cost of education, with high-income families having so much more money to throw at their children's education.