INVESTING IN A CHILD S EDUCATION

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1 F ULLY REVISED AND UPDATED Includes information on how to take advantage of the new Canada Education Savings Grant INVESTING IN A CHILD S EDUCATION YOUR GUIDE TO SAVING FOR A CHILD S POST-SECONDARY EDUCATION 7851 (07/2000) Member of Royal Bank Financial Group Registered trade-mark of Royal Bank of Canada

2 d WHAT ARE YOUR EDUCATIONAL SAVINGS OPTIONS? REGISTERED EDUCATION SAVINGS PLANS page six SELF-DIRECTED RESPS page sixteen NON-REGISTERED EDUCATION SAVINGS page twenty two TRUSTS page twenty nine d THE IMPORTANCE OF HIGHER EDUCATION In a survey commissioned by Royal Trust of more than 500 wealthy Canadians, more than twothirds of the respondents credited education as one of the keys to their success. It ranked second only to willingness to work hard. When asked what advice they would give to others seeking financial success, their number one response was: Get as much education as possible. It should come as no surprise that these people had reaped the benefits of their own advice: 86 per cent of them had received some form of post-secondary education. LIFE INSURANCE page thirty nine OPTIONS AT-A-GLANCE page forty four Readers are advised that the material contained in this booklet is intended solely for information purposes and should not be used as a substitute for consultation with a legal, tax or financial services professional. The information contained herein is based on sources which Royal Mutual Funds Inc. ( RMFI ) believes to be reliable, but is not guaranteed to be accurate, and does not purport to be a complete statement or summary of the available data. Any opinions expressed are subject to change without notice. The unitholders, directors, officers and employees of RMFI are not responsible for errors or omissions. Get as much education as possible. one

3 d Education has always opened doors. And our society s growing reliance on technology is fuelling an unprecedented demand for skilled workers with advanced education and specialized training. The most recent figures from Statistics Canada report that from 1990 to 1997, there were 1,833,000 new jobs created for post-secondary graduates. During that same period, the number of jobs for those without higher education fell by 1,058,000. Approximately 41 per cent of Canadian jobs were held by individuals with post-secondary credentials in 1990, and as the decade drew to a close the number had grown to over 52 per cent. Meanwhile, those without high school diplomas saw their share of the job market fall to only 18 per cent. In fact, young people without high school diplomas are 2.4 times more likely to be unemployed than post-secondary graduates. As a final incentive, consider that post-secondary graduates have higher earnings than high school grads. Average salaries are significantly higher for those who are graduates of colleges and universities according to 1995* census figures. W THE RISING COSTS OF EDUCATION In the past 10 years, tuition fees at Canadian colleges and universities have more than doubled and the trend is not expected to improve any time soon. Government cutbacks are escalating. With their subsidies shrinking, schools are being forced to develop alternative funding strategies. Unfortunately, tuition hikes are often seen as the answer. At several Canadian universities, for example, annual tuition fees for MBA programs are approaching $20,000. As well, there is a growing trend toward charging higher fees for more popular programs, such as computer science, business, and engineering. Unfortunately, tuition costs are only part of the problem. Accommodation, living expenses, books, activity fees and the like will also continue to hit students right in the pocket-book. LEVEL OF EDUCATION AVERAGE SALARY Grades 9-13 but without a diploma $18,639 Grades 9-13 with a diploma $22,846 Less than university degree $25,838 University degree $42,054 *latest figures available from Statistics Canada two three

4 W A Until recently, it was thought that the full cost of a four-year undergraduate degree at a Canadian university would hit $100,000 in about 15 years. But with the blistering pace of both cutbacks and tuition hikes, six-digit tuition fees may be much closer than anyone had previously imagined. Even more disturbing, the Canadian Federation of Students estimates that current university graduates will leave school with $25,000 in outstanding loans. How much more could it be for the next generation of graduates? WHAT IS AN EDUCATION SAVINGS PLAN? With individuals facing increasingly higher costs for post-secondary education, the answer is a formal plan to save and invest. What are your choices? In a nutshell, an education savings plan is any type of savings plan earmarked to fund a post-secondary education. It can be as simple as a savings account, or as complex as a portfolio of stocks and bonds. Six-digit tuition fees may be closer than anyone had previously imagined. four The government recognizes the importance of education, and its own limitations in providing affordable education to Canadians. To alleviate some of the burden, the government offers a tax incentive to encourage families and students to save for post-secondary education on their own. If you wish to take advantage of special tax rules, you can accumulate these savings in a Registered Education Savings Plan (RESP). An RESP enables you to defer or postpone the tax on any investment income that your plan generates. Although contributions are not tax-deductible, any earnings generated by your plan are permitted to grow on a taxdeferred basis. (For full details, see the section on RESPs later in this Guide.) As well, under the recently-announced Canada Education Savings Grant (CESG) program, the government will match 20% of contributions to a maximum annual grant of $400 per beneficiary. Of course, RESPs are not the only way to save for future education goals. You can always put money aside for the benefit of your child using a variety of other approaches and investments. WHAT ARE YOUR EDUCATION SAVINGS OPTIONS? There are many ways to save towards future education costs, and each has its own set of advantages and disadvantages. Some offer considerable long-term growth potential; with others, security is a key benefit. five

5 A U This section will review the different choices available for your education savings program. These are: Registered Education Savings Plans (self-directed and pooled trust) Non-registered education savings Trusts (formal and informal in trust ) Life insurance As you review each of these investment options, you ll want to keep your own objectives and expectations in mind. Is deferring taxes more important than flexibility? What kind of growth rate do you hope to achieve? How much are you willing to spend in fees and expenses? And what will you do if the beneficiary decides not to pursue higher education? REGISTERED EDUCATION SAVINGS PLANS An RESP is a savings vehicle to which you contribute money over a period of time. The money in the plan is intended to help your beneficiary finance a post-secondary education at a qualifying institution. The types of investments you can hold vary according to the type of RESP you select. With some RESPs, your money is pooled with that of other participants and invested on your behalf. With others, such as a self-directed RESP, you can select your own investments from the company s mutual funds or other investment choices. six HOW AN RESP WORKS Although RESP features and investment options differ widely from company to company, the overall Federal laws governing them are the same. Below is a brief overview of the main rules: You choose the beneficiary when you set up the plan. It can be anyone, including your children, grandchildren, nieces, nephews, or family friends. Beneficiaries of a family RESP must be related to you by blood or adoption, and be under 21 years at the time designated as beneficairy You can invest up to $4,000 per beneficiary, per calendar year, up to a lifetime maximum of $42,000 per child. Once you start contributing, all of your capital appreciation, including interest, capital gains, and dividends, is allowed to grow on a tax-deferred basis. Contributions themselves are not tax-deductible (as they are with a Registered Retirement Savings Plan), but your money is allowed to accumulate without any income tax liability, until the beneficiary enrolls in a qualifying postsecondary program and begins to receive educational assistance payments. Most plans permit that, at any time, all of the principal you contributed into the plan can be returned to you (less any fees or charges). As this is simply a return of the money you contributed, which you were already taxed on, you don t have to pay any additional income tax on it. Most plans permit accumulated growth to be withdrawn, subject to conditions, by you or transferred to your RRSP or a spousal RRSP, should beneficiaries not pursue higher education. Since January 1, 1998, RESP contributions are eligible for the government s new Canada Education Savings Grant (CESG). For more details on this, see the section How the CESG Works on page 13. seven

6 U U When the Beneficiary is Ready for Post-Secondary School When the beneficiary is enrolled full-time in a qualifying post-secondary program, you can direct the plan s accumulated earnings, including any grant money received, to be distributed as educational assistance payments (EAP) to, or on behalf of, the student. An EAP can also be paid to a student not in full-time enrollment where the student has a mental or physical impairment and medical documentation that states that the effects of the impairment are such that full-time enrollment is unreasonable. In most cases, the EAPs are spread out over the number of years the student expects to be enrolled. All of the money distributed in this way is taxed in the student s hands. In most cases, the student s income level and eligible tax credits will mean that little, if any, income tax will be payable. The amount of an EAP can be limited to $5000 in certain cases, such as during the first 13 weeks of enrollment. Your actual contributions to the plan can be withdrawn as a refund of payments, tax-free, and either returned to you or directed to the student to assist them with their educational costs. If the Beneficiary Does Not Go On to Further Studies If your original beneficiary decides not to pursue higher education, you may have several options available, depending on the type of RESP you have: 1. Share with other beneficiaries With some plans, the accumulated earnings can be distributed as EAP among the other beneficiaries of a family plan if a particular beneficiary does not go on to post-secondary school. 2. Designate another beneficiary Some plans will let you select another eligible beneficiary to receive the proceeds. However, if the plan has received grant money through the CESG program, changing beneficiaries could trigger a repayment of the remaining grant pool to the government. 3. Withdraw your contributions Most plans permit a tax-free withdrawal of all the money you contributed to the plan. However, a withdrawal of contributed funds that is not used for educational purposes, may trigger a CESG repayment from the RESP to the government equal to 20% of the withdrawal. Any growth generated by the repaid grant would remain in the plan. In addition, withdrawal of unassisted contributions may result in temporary suspension from the CESG program until the end of the second following year and loss of grant contribution room for those two subsequent years. If your original beneficiary decides not to pursue higher education, you may have several options. eight nine

7 U 4. Withdraw your growth You may be able to access the RESP s accumulated growth (excluding grant money), either by withdrawing it in cash or by transferring it to an RRSP. Generally, to take advantage of these options, the RESP must have been in effect for at least 10 years, and the beneficiary must have reached age 21 and be ineligible to receive educational assistance payments. The cash withdrawal of accumulated growth will be subject to income tax in the year it is withdrawn, along with an additional 20% penalty. If you have allowable RRSP contribution room, you can transfer up to $50,000 from the RESP into your RRSP or a spousal RRSP as a regular RRSP contribution. The amount transferred into an RRSP in this manner will not be subject to income tax or the 20% penalty. Any grant pool still remaining in the RESP must be repaid to the government. 5. Donate the money to an educational institution You also have the option of directing the plan s accumulated growth to a designated educational institution. In this case, you will still be able to withdraw your contributions (less fees and expenses), but you will forfeit the plan s accumulated growth and remaining grant pool. Please remember that this brief overview does not take into account the many special rules governing such matters as death, marriage breakdown, relationship requirements, grant limitations and restrictions, transfers, beneficiary changes, etc. These rules are complex. Your tax, financial, or legal advisors can help you determine how they may affect your RESP. U WHICH SCHOOLS QUALIFY? As a condition of investing in an RESP, the student must use EAPs from the plan to attend a qualifying educational program at a qualifying post-secondary educational institution. The definition of a qualifying school depends on the terms of the plan. In some cases, only colleges and universities are recognized. With other plans, a qualifying school is more broadly defined to include: a) Designated educational institutions: all Canadian universities and colleges; Canadian educational institutions designated by the Federal government or a provincial government; and b) all Canadian educational institutions that are certified by the Ministry of Human Resources Development, such as trade schools and technical institutes; and c) most universities, colleges or educational institutions outside Canada provided the student beneficiary is enrolled in a post-secondary level course of at least 13 weeks. With non-registered investment plans, there are no restrictions on how the money can be used, and no limits on the types of institutions the student can attend. ten eleven

8 U U RESP CONTRIBUTION LIMITS You are permitted to contribute up to $4,000 per beneficiary, per year, to an RESP. The lifetime maximum per beneficiary is $42,000. These limits apply to the beneficiary, not to the contributor. You can invest in as many RESPs as you like, as long as the total contribution amounts per beneficiary, from all contributors, does not exceed the maximum limits. Should the maximum limits be exceeded, a Revenue Canada penalty will be incurred by the contributor(s). To be eligible for any given year, contributions must be made between January 1 and December 31. There are no carry-forward provisions for RESP contibutions. With more flexible plans, you can invest in the RESP at any time for up to 22 years (year plan opened + 21 years). After that, no further contributions can be made. Although the plan is closed to new contributions, it can remain open for up to 26 years (year plan opened + 25 years). At that time, if all of the capital appreciation in the plan has not been paid to the student beneficiary, it may be taken in cash, rolled into an RRSP or spousal RRSP or paid to the designated educational institution of your choice. Your options will depend on the type of RESP you have. HOW THE CESG WORKS RESP contributions made after January 1, 1998 are eligible for the government s new Canada Education Savings Grant (CESG). Under the CESG program, annual RESP contributions of up to $2,000 qualify for government assistance up to the end of the year that the plan s beneficiary turns 17 years old. The government will match 20% of your contributions to a maximum annual grant of $400 ($2,000 x 20%) per beneficiary. Even if you do not make an RESP contribution in a given year, the RESP beneficiary still earns $2,000 of granteligible annual contribution room each year even during those years prior to becoming an RESP beneficiary. In other words, all children, whether they already have RESPs or not, will begin accumulating grant contribution room from the later of January 1, 1998 and year of birth. Any unused grant-eligible contribution room can be carried forward to produce a maximum annual grant of up to $800, per beneficiary, in any given year (assuming there have been $4,000 in contributions and carry forward grant room of at least $2000 that year). The maximum cumulative grant over the life of the RESP is $7,200 ($400 x 18 years). Annual RESP contributions of up to $2,000 qualify for government assistance. twelve thirteen

9 U U Although the grant is generally available up to the end of the year the beneficiary turns 17, there are special rules for beneficiaries for the years they turn 16 and 17. In these cases, the grant will be awarded only if there have been RESP contributions of at least $100 per year in any four years before the year of turning 16, or the plan s cumulative contributions total at least $2,000 before the year of turning 16. The CESG does not reduce your annual contribution limit to an RESP. For example, you could invest the maximum $4,000 annual contribution and still receive up to $800 of grant. As well, with more flexible self-directed RESPs, you have full control over how the grant money is invested. One caveat with the CESG is that if you withdraw any of your original contributions before the plan matures, you may trigger a CESG repayment or suspension from the CESG program. Therefore, it s usually best to defer such a withdrawal until after the last education assistance payment has been made. Other CESG repayment transactions include: plan termination or payment to a DEI education payment to a non-beneficiary the entire plan is transferred to a new plan unless: a) at least one beneficiary becomes a beneficiary of the new plan; or b) a beneficiary is the sibling of a beneficiary under age 21 of the new plan a partial transfer of a plan The CESG does not reduce your HOW TO CAPITALIZE ON THE NEW RESP GRANT The introduction of the Canada Education Savings Grant (CESG) makes RESPs a compelling way to save for future education goals. However, if you want to take advantage of the CESG program, the child must be: a resident of Canada a beneficiary of a RESP have a Social Insurance Number (SIN) under the age of 18 throughout the year in which a contribution is made (subject to special rules for 16 and 17 year olds). The introduction of the CESG makes RESPs a compelling way to save for future education goals. annual contribution limit to an RESP. fourteen fifteen

10 o SELF-DIRECTED RESPS Self-directed may sound more intimidating than it really is. A self-directed RESP is simply an account, governed by RESP rules and restrictions, over which you have investment control. These accounts are offered by a number of financial institutions and investment companies. Most of these self-directed accounts enable you to choose from investment options offered by that company. The selfdirected features will allow you to enjoy the investment potential of mutual funds, for example, in addition to the tax-deferral benefits of an RESP. o ADVANTAGES OF A SELF-DIRECTED RESP Contributions are eligible for the CESG. Combines the growth potential of mutual funds and other investments with the tax-deferred earnings of an RESP. Although investments must be Qualified Investments (i.e. same as for RRSPs and RRIFs), there is a wide selection available. Unlike an RRSP, there are no foreign-content limitations on your RESP accounts. You are free to take full advantage of international investment opportunities. Usually has very flexible rules for beneficiary designation. If the plan s original beneficiary chooses not to go on to higher education, you can name another beneficiary, or even use the money yourself if you attend a qualifying program at a qualifying school. If you contribute through a pre-authorized investment plan, you can invest with as little as $25 a month. You retain full control over how your money is invested. Mutual fund investments are generally easy to redeem. This means you can adjust your holdings as you see fit. IMPORTANT POINTS TO CONSIDER The RESP s accumulated growth and CESG may be forfeited if principal is withdrawn early, or the child does not pursue post-secondary education. To get the most from your investments, your portfolio needs regular monitoring, review and possible adjustment to ensure it meets your objectives. Some plans require an initial deposit of $500 or more to open the account. Depending on the underlying investments in the plan your capital may not be guaranteed. Funds must be used for the purpose of assisting in financing the child s post-secondary education. sixteen seventeen

11 V OUR ADVICE The flexibility, tax advantages, and growth potential of this option make it one of the better choices for your education savings. You will benefit even more if you have the discipline to maintain a regular savings program. (Setting up a pre-authorized investment plan can help with this). POOLED TRUST PLANS Pooled trust plans are offered by several Canadian scholarship trust companies. They are perhaps the best known of the registered educational savings vehicles. When you subscribe to one of these plans, you agree to buy a certain number of shares (called units), and to pay for them over a specified period of time. The company then combines the money from its subscribers, and invests it for them in very secure fixed-income investments. When your beneficiary enters a qualified post-secondary school, the money you contributed (less fees and administration charges) is returned to you with the intention that it will be used to pay for the first year of school. When the student enters second year, the interest payouts begin (called scholarships by these firms). Your beneficiary s share of the pool is determined by the number of units you purchased. The value of those units is determined by several factors, including: Interest rates. By law, all of the plan s investments must be held in debt securities that are either insured or V government-guaranteed, such as Treasury bills and government bonds. So returns on these investments tend to be conservative. Number of participating students. The more students who are sharing in the interest pool, the fewer dollars there will be for each individual. Generally, there is a separate pool established for each calendar year. Your pool is determined by the year in which you establish your RESP. Subscribers who stop contributing. If subscribers stop investing in their plans before maturity, or the beneficiary doesn t go on to higher education, the contributions will likely be returned to the subscriber and the earnings forfeit, leaving more money in the pool available for the other participants. The more students who are sharing in the Interest pool, the fewer dollars there will be for each individual. eighteen nineteen

12 V V ADVANTAGES OF POOLED TRUST PLANS Contributions are eligible for the CESG program. Investments held in these plans are very secure. There is little chance of losing your principal. Because it s a formal RESP, the money grows on a taxdeferred basis. In other words, there is no immediate income tax bite on your earnings. Contribution minimums are very low, in some cases you can invest with as little as $10 a month. They provide young people with a strong incentive to attend post-secondary school. IMPORTANT POINTS TO CONSIDER The plan s investment portfolio consists solely of cash and fixed income securities. These provide only modest longterm growth and may not always keep pace with inflation. Payouts are governed by factors you cannot control, including the number of other students participating in your pool (or dropping out of it). Up-front fees are relatively high. In most cases, enrollment fees come off the top, like the front-end load on a mutual fund. They can be as high as $200 per unit. There are no partial scholarship payouts. If you stop investing at any point before your plan matures, you may receive only your principal, less any fees or penalties. If you also forfeit growth, all of your interest goes into the pool for the rest of the beneficiaries. With most plans, student must continue their studies uninterrupted. If they leave school before graduation, or take off a year or two, payouts may cease. Pooled plans are designed exclusively for young children. In most cases, enrollment of the beneficiary is restricted to children under the age of 13; contributions cannot be made after the child s eighteenth birthday; and scholarships must be used before age 21. For example, if you enroll a six-year-old child, you have only 12 years in which to contribute. Flexibility is often a problem. Not all schools are recognized by all plans. Some place severe restrictions on changing the plan s beneficiary. There are some plans with better flexibility, but they come with higher fees and lower scholarships. Some plans will not allow you to transfer the scholarships to another student if the person for whom the plan was originally intended does not go on to post-secondary school. In addition, withdrawal or transfer to an RRSP of plan growth may not be permitted. In these cases, all of the plan s earnings will be forfeit. OUR ADVICE If you might not otherwise have the discipline to maintain a long-term savings program, or if you cannot afford the minimum monthly investment required by other plans, a pooled trust plan could be an appropriate choice. If you are interested in one of these plans, shop around. Fees and flexibility can vary considerably. Read the Declaration of Trust carefully; you may also want to seek professional legal advice to fully understand it. Some plans will not allow you to transfer the scholarships to another student. twenty twenty one

13 V V NON-REGISTERED EDUCATION SAVINGS Suppose you want more flexibility than RESPs offer. In that case, you can save and invest in a non-registered account. The drawback is that non-registered investment accounts don t offer the same tax-deferral benefits of formal RESPs nor can you take advantage of the CESG program. Any income and realized net capital gains on investments outside an RESP will be subject to applicable income tax in the year that it is earned, sometimes in the hands of the contributor and sometimes in the hands of the beneficiary. Unrealized capital gains (losses) are tax-deferred until realized by a disposal of the related asset(s) which can be deferred for years. Without the restrictions of a formal plan, you can put money aside in any investment you like bank accounts, GICs, mutual funds, stocks, bonds, and more. Non-registered investment accounts give you greater control and flexibility with how the money is used. And there is no forfeiture of account growth if the plan s intended beneficiary does not attend a qualifying post-secondary school. Full details on your non-registered investment account options, their tax implications, and suitability for education savings are covered in the next section. YOUR NON-REGISTERED INVESTMENT ACCOUNT OPTIONS Just about any investment can be used as a vehicle to fund post-secondary education, including bank accounts, term deposits, Guaranteed Investment Certificates (GICs), stocks and mutual funds. Of course, some of these investments provide considerable growth potential, while others are known for their secure but more limited returns. If you are not registering your investments in a formal RESP, you can hold virtually any security you want. And down the road, you can use the money in any way you wish. When considering an investment for a non-registered education savings plan, be sure to consider its growth potential, liquidity (how quickly it can be converted into cash, in case of an emergency), convenience, security and tax treatment. For example, a stamp collection might have tremendous growth potential, but could be difficult to sell for fair value at tuition time. BANK ACCOUNTS Bank accounts pay minimal interest. As well, because of their high liquidity (the accessibility of the money), contributors may be tempted to dip into their savings. In reality, there are many better options available for long-term savings. twenty two twenty three

14 V V Use your bank account as a place to deposit the money you plan to invest in your education savings plan. Then set up your plan so that a pre-authorized amount is deducted from the bank account each month. GUARANTEED INVESTMENT CERTIFICATES These term investments are sometimes used for education savings because people are familiar with them and because they are secure. However, they can lack the liquidity and growth potential of other investments. CANADA SAVINGS BONDS For years, parents and grandparents have used Canada Savings Bonds to help put their young scholars through school. Because CSBs have high liquidity, are issued by the Government of Canada and can be purchased through payroll deduction, CSBs are popular with many Canadian investors. And they do let you know exactly how much your investment will be worth over a given period of time. Some parents like to purchase shares of kid-friendly companies, such as Disney or Mattel, for their children. A portfolio made up only of these kinds of securities may lack the diversification necessary for the best long-term potential. MUTUAL FUNDS Growth-oriented mutual funds offer most investors the opportunity to keep pace with inflation, tuition hikes, and investment markets. With a time horizon of seven to 10 years or more, equitybased funds can be a wise choice during the early years. As the student progresses through high school, holdings can be shifted to focus on more conservative funds to preserve the capital that has been accumulated. But like GICs, they are unlikely to provide the long-term growth potential you will need to keep pace with rising tuition fees and inflation. STOCKS (EQUITIES) These can be a good option for investors with the time and confidence to manage a portfolio of stocks. However, for most investors, it s difficult to ensure proper diversification, and to stay up to date with the prospects for each stock. Active trading can also be costly. It s difficult to ensure proper diversification. twenty four twenty five

15 V V HOW YOU CAN HOLD THESE INVESTMENTS Non-registered investments earmarked for your educational savings program can be held in your name or in trust for the child. Each option presents different ownership, control and tax consequences. If the investments are held in your name, all of the income earned on them will be taxed in your hands in the year it is earned. As well, you retain ownership of the investments for life. If you don t want to give it to your teenager to backpack across Europe, you don t have to. Alternatively, investments that are held in trust for the child under 18 years old, may offer certain income-splitting opportunities. If the in-trust account is constituted and recognized as a trust, all first generation income earned by the investments is attributed to the contributor, while second generation income (income earned on income) and realized net capital gains can be taxed in the hands of the beneficiary. On January 1st of the year the child turns 18, income is no longer attributed to the contributor. At that point, all further earnings will be taxed in the child s name. Once the beneficiary reaches the age of majority, you may lose control over the in-trust account. (See section on Informal In Trust Accounts). Income attribution will cease at age 18. ADVANTAGES OF NON-REGISTERED EDUCATION SAVINGS Ability to invest in a variety of securities, some of which may not be available within a particular formal RESP, including GICs, Canada Savings Bonds, and mutual funds. The amount you can invest has no limit placed on it. There are no constraints on how the money can be invested or spent. If invested in your name, you retain full control over the money. IMPORTANT POINTS TO CONSIDER Investments are not eligible for the CESG program. There is no tax deferral on the plan s earnings, and realized net capital gains. All of the earnings will be taxed in your hands; however, depending on the arrangement and/or income attribution rules applicable, second-generation income may be taxable in the child s hands, along with the realized net capital gains. Depending on the investment, your capital may not be guaranteed. OUR ADVICE Other than your RRSP, your educational savings program is probably the biggest and longest-term savings commitment you will make. This means that your time horizon is appropriate for growth-oriented options such as equities. Along with their built-in diversification, liquidity, and convenience, equity-based mutual funds provide most investors with their best opportunity for long-term growth. twenty six twenty seven

16 u INVESTING FOR INTERNATIONAL BENEFITS Diversification is one of the keys to successful investing. International growth funds offer you yet another way to diversify your education savings, by investing outside Canada. Today, specialty mutual funds have been created to cover virtually every region of the globe, from superpower economies like the U.S., to Europe and the so-called emerging markets. These mutual funds give Canadian investors the opportunity to diversify their holdings internationally, and capitalize on the growth potential in other countries. At the same time, they can offer a hedge against fluctuations in the Canadian dollar. International funds invest in securities denominated in many currencies. This gives investors the opportunity to benefit from currency exchange movements. Not only can this help reduce volatility caused by swings in any one currency, including our own, it can also help to improve returns. As part of a balanced portfolio, international funds can potentially help reduce volatility while enhancing the longterm performance of your portfolio. g TRUSTS Trusts are legal arrangements that can determine how assets (such as your investments) are invested, administered and distributed. When it comes to education savings, there are three trust options to consider: A formal living trust (intervivos trust), an informal in trust arrangement, and a pooled trust plan. INTER VIVOS TRUSTS One important option is an inter vivos trust, also called a living trust. This is a formal trust arrangement in which you, the settlor, transfer the legal title of assets or contribute cash to a trust with instructions to one or more trustees as to how the property is to be used for the benefit of the trust s beneficiary. You can establish a living trust for the benefit of anyone, including your children, grandchildren, nieces, nephews, or family friends. Many types of assets can be held in a living trust, assuming the trust agreement permits, including cash, bank accounts, real estate, stocks and bonds, and shares in your business. Keep in mind that although many assets are eligible for inclusion, some are more appropriate to your education savings goals than others. Moreover, the 1999 federal budget introduced measures to discourage minors from earning income from a family business or private corporation. You can establish a living trust by creating and signing a trust agreement, usually prepared by a lawyer or notary, and transferring ownership of the designated assets to the trustee of the trust. You can choose to retain control over the assets by naming yourself as one of the trustees, but twenty nine

17 g you will lose some of the potential tax advantages. Alternatively, you could name two or three co-trustees. You can make the trust revocable or irrevocable. With a revocable living trust, you can change your mind at any time and take back some or all of the trust s assets. This flexibility does, however, have a cost in that all income and capital gains of the trust will be included in your income for tax purposes as if the trust never existed. That could be a costly consequence over time. With an irrevocable living trust, you cannot change or cancel the terms of the trust. You give up your right of ownership when the assets are transferred into the trust. In return, you can achieve some tax advantages. Any income or capital gains generated that are not paid (or payable) out of the trust are taxed within the trust each year. Any income that is so allocated will be taxed to the beneficiary, if the beneficiary is 18 years of age or older. If the beneficiary is under age 18, first generation interest and dividends paid to a minor will be taxed in your hands. All second generation interest and dividend income (income earned on income) and realized net capital gains allocated to a minor will not be attributed back to you. g The trust can be non-discretionary or discretionary. If it is non-discretionary, the trustee is directed when to pay out income, and the capital as set out in the trust agreement. If it is discretionary, the trustee makes some or all of these decisions. This allows you to arrange for the beneficiary to receive a regular income from the trust s assets over a given period of time. This can be an advantage while the student is in school, or in providing a controlled amount of income should the beneficiary choose not to go to school. With an irrevocable living trust, you cannot change or cancel the terms of the trust. thirty thirty one

18 g g ADVANTAGES OF A LIVING TRUST No contribution limits. No age limits for the contributor or the beneficiary. If the investments held in the trust are aimed primarily at generating capital gains, this can provide an excellent income-splitting opportunity provided the trust agreement is properly drafted. If investments generate income, good income-splitting opportunities can exist for second generation income. If you already have specific assets you want to use to fund your child s education, this can be a good option. OUR ADVICE If you have substantial wealth, or highly complex finances, a living trust might be a good choice. Otherwise, you might be better served with one of the other educational savings options. IMPORTANT POINTS TO CONSIDER First generation dividend or interest income generated and paid (or payable) to a beneficiary will be taxed back to you if the beneficiary is under 18 years old. There is a deemed disposition of the assets every 21 years which requires advance consideration. Income not allocated to a beneficiary is taxed in the trust at the top marginal tax rate. There may be tax consequences to you when you transfer certain assets to the trust. Investments are not eligible for the CESG program. Formal trusts can be complex. Professional advice is essential to ensure the trust meets your objectives and the benefits outweigh the costs. Professional advice is essential to ensure the trust meets your objectives and the benefits outweigh the costs. thirty two thirty three

19 g INFORMAL IN-TRUST ACCOUNTS You can designate just about any investment in trust for your child by opening an account and writing in trust for and the beneficiary s name on the investment application form. There are two possible situations where an in trust account may be considered; each has different legal and tax implications: 1. Money belonging to the child - An Agency Relationship A parent, grandparent or guardian can set up an account in- trust for a child to manage money that the child has received as a gift from an unrelated party (deals at arm s length with the minor), through inheritance, or from Child Tax Benefit payments. The money belongs to the child but the investment decisions are made by the adult until the beneficiary reaches the age of majority. In this situation, the account is established with the child s Social Insurance Number and all investment earnings can be taxed in the minor s hands. Where the source of money is a gift from a related party to a non-arm s length minor, the income attribution rules will apply as described below. 2. Money to be used for the benefit of a child - A Trust Relationship If a parent, grandparent, guardian or other related party wants to set money aside for the benefit of a child, investments registered in trust for the child may offer certain tax advantages. These benefits will be realized if the in-trust account is constituted and recognized as a trust. thirty four g Revenue Canada may treat the in-trust account as a trust for the benefit of the beneficiary, although no T3 Trust Return will be required, and allow some income-splitting opportunities, provided: the trustee, the property and the beneficiary are clearly identified. An account set up with the trustee s name in trust for the beneficiary s name, which holds specific investments, should meet this requirement. the account is operated as a trust for the beneficiary, meaning that the money in the account is used only for the benefit of the child. the person who contributes to the account (the settlor ) is different from the person who makes the investment decisions for the account (the trustee ), and the settlor can support their intention to create a trust. In the absence of a formal written document that spells out the terms of the trust, the best way to demonstrate an intention to create a trust is to set up and operate the account as discussed above. Although this approach does not give you the tax-deferral advantages of a formal RESP, it does provide some incomesplitting opportunities with a minor under age 18. Any realized net capital gains earned on investments held in trust for a minor can be taxed in the minor s hands. In other words, if you invest in capital-gains producing investments, you should be able to effectively transfer much of the tax liability for those earnings to your child (or any related or non-arm s length minor under age 18) who will likely be in a lower tax bracket. thirty five

20 g g All first generation dividend and interest income is attributed to the settlor who contributes the money to the in-trust account. Second generation income (ie. income earned on income) is generally not attributed to the settlor and is taxed in the hands of the child; this can result in a significant incomesplitting opportunity after several years of reinvestment. On January 1 of the year the beneficiary turns 18 attribution to the settlor will cease and any future income and capital gains will be taxed in the beneficiary s hands. The attribution rules will also cease on death of the settlor, or where either the settlor or beneficiary becomes a non-resident of Canada. Regardless of the type of in-trust arrangement, many financial institutions will only take instructions from you, the client, and never the beneficiary even after the beneficiary has reached the age of majority. If the beneficiary has reached the age of majority, and you deny the beneficiary access to the in-trust account, he or she can ask the courts to grant it. If the court orders a distribution to the beneficiary, you will lose control over the account and its assets, Furthermore, there could be potential legal complications over the ownership of the account s assets, if you or the beneficiary dies. Whether tax slips use the SIN number or the trustee or beneficiary, it is the trustee s responsibility to ensure that the income attribution rules are correctly applied. Different financial institutions have different interpretations of the rules that govern in-trust accounts. Check with your financial institution and legal and tax advisors before you invest. thirty six ADVANTAGES OF IN-TRUST ACCOUNTS FOR MINORS No contribution limits. No deadline on when the money must be used. No restrictions on how the money can be used providing it is for the benefit of the beneficiary. Any realized net capital gains earned by the investments can be taxed in the minor s hands, usually with little or no tax payable. Similarly, second-generation income will generally be taxable in the minor s hands. If you choose your investments carefully, you can minimize any interest and dividend income (since first generation income will attribute back to the contributor). Equity funds, particularly those specializing in shares of growth companies, don t usually generate significant interest or dividend income. IMPORTANT POINTS TO CONSIDER If the person who contributes to the account and the person who makes the investment decisions for the account are the same person, the income splitting advantages associated with the arrangement may be lost. First generation income is taxable in your hands. You may eventually have to relinquish control over the funds. You cannot use the funds for the benefit of anyone but the beneficiary, or all income and capital gains will be taxed in your hands. Depending on the interpretation of the rules at the financial institution where you have invested, control over the investments may transfer to the beneficiary when they reach the age of majority. The money may not be used in the manner you had intended. thirty seven

21 g In cases where the informal in-trust arrangement is not considered a formal trust, family problems could arise if the beneficiary goes to court to order a distribution of the assets in the account. Some investments, may not be an eligible investment within a trust, unless authorized by the trust legislation in your province. Therefore the beneficiary of an informal trust may have the right to go to court to recover any losses resulting from unauthorized investments made by the trustee. Investments are not eligible for the CESG program. Informal trust arrangements lack the certainty provided by a written trust document and therefore may be open to a different interpretation by Revenue Canada or the beneficiary than you had intended. Uncertainty can be reduced by using a Declaration of Trust signed by the settlor. The rules relating to informal trusts can be complex and may change over time. Professional advice is essential to ensure the account meets your objectives. OUR ADVICE Depending on your circumstances, an informal in-trust arrangement may be a good option for those who have already maximized their RESP contributions or those who are uncomfortable with the restrictions of a formal RESP. LIFE INSURANCE Most life insurance companies offer at least one cash-value life insurance plan that s available to parents as an educational savings plan for their children. These insurance plans combine life insurance on the child s life with a savings or investment component. A portion of each premium dollar goes to pay for the life insurance and a portion is invested on the child s behalf for the future. A full range of investment choices Your cash-value may be based on the performance of the insurance company s fixed-income investments. Or, you can choose how you want to invest your savings, usually from a selection of the company s guaranteed interest accounts, index-linked accounts (linked to the performance of a stock market indicator such as the TSE), or segregated funds (similar to mutual funds). These life insurance plans cannot be registered with Revenue Canada as an RESP, but they do offer their own tax-deferral benefits, similar to your RESP. If you receive a windfall or inheritance that exceeds the RESP contribution limit and its size does not justify the expense involved in setting up a formal trust, an informal in-trust arrangement could be a good way to share the wealth with your children or grandchildren. The person who gives property to an informal trust should not be the person who controls the in-trust account. Otherwise, income and capital gains may be attributed back to the settlor even after the beneficiary reaches age 18. thirty eight thirty nine

22 Tax-deferred Growth The cash value (your investment and earnings) that accumulates in your policy is allowed to grow on a tax-deferred basis. When you withdraw your investment component (generally as a policy loan or when you cash in your policy), often only the earnings on your investment portion are taxable at the policyholder s current income tax rate at the time of the loan or withdrawal. Use the investment fund as you wish If the student does not continue with post-secondary education, there is no loss of investment funds or earnings. And there are no restrictions on how or when your money can be used. Does your child need insurance on his/her life? This consideration should be made separately from your educational savings objectives. Life insurance on your child can provide a guarantee that your child will have life insurance later in life regardless of future health conditions. Your child s insurability does not depend on whether he/she has future education plans. So please be sure to consider these two issues separately when considering life insurance. ADVANTAGES OF LIFE INSURANCE FOR EDUCATIONAL SAVINGS Virtually no limits on the amount you can invest, subject to the child s insurability. No restrictions on how or when the money can be used. Earnings are tax-deferred until withdrawal. Policies can often be fully paid-up with an accelerated payment schedule. Life insurance exists from the first day a policy is issued; death benefits from a tax-exempt policy are non-taxable. Various protection features can be included such as a disability waiver for the payor and guaranteed life insurability for the life insured. The policy can often be transferred to the life insured on a tax free basis, where the life insured is a child or spouse of the policyholder. IMPORTANT POINTS TO CONSIDER Be sure to find out what the cost of the insurance is, and how much of your deposit is actually going into the savings or investment component. Normally a medical questionnaire is required to establish insurability. Projected cash values could be much lower than actual performance. forty forty one