Saving in advance of a need makes financial sense. For example, starting a sinking fund or savings plan early can help parents fund the cost of higher learning for their children. Without an established pool of funds, many families would have a hard time finding the cash flows needed to finance education expenses. With an important need such as education, and a gap in the necessary cash flow, the result is that many families turn to an alternative funding source — debt — in order to provide for their children’s education. The long-term implication is that this debt creates a legacy that needs to be repaid over time. Parents may be forced to delay retirement, and children may struggle with significant debt early in their careers.
The federal government revamped registered education savings plans (RESPs) in 1999, in an effort to encourage taxpayers to save for the cost of educating their children. Over time, the rules have been enhanced and the savings incentives increased. Currently, if a parent can contribute $2,500 per year into an RESP on behalf of his or her child, a government grant of $500 is also contributed to the plan. The rules contain lump sum, lifetime and catch-up provisions for contributions and access to the grants. There is no income tax on the earnings accumulating in the plan until they are withdrawn.
But are RESPs the only means of providing for the cost of higher education? Do business owners and incorporated professionals have alternatives?
In order for a business person (in this article defined as the owner of a private corporation, either business or professional) to contribute to an RESP, he or she would likely need to take income out of the company. But when withdrawing funds from the company, income taxes have to be paid at either the corporate or personal level.
The following chart shows how $4,545 of corporate income flows through to become the after-tax amount retained by the shareholder for an RESP contribution:
|Salary / Bonus||Dividend|
|Pre-tax corporate income||$4,545||$4,545|
|Salary / Bonus||$4,545|
|Corporate tax rate||17%|
|Taxable salary /bonus||$4,545|
|Personal tax rate||45%||34%|
|Net after tax amount||$2,500||$2,500|
In order to have $2,500 after-tax available for an RESP contribution, the government collects $2,045 in income taxes at either the individual level or the corporate and individual levels combined.
A business person has options when funding higher education for family members. One strategy that should be considered is income splitting. A business person could restructure the company to introduce his or her children, or trusts for the children, as shareholders of the company. Professionals in many provinces can have family members as shareholders of their professional corporation.
Money could then be accumulated in the company with the intention of paying dividends to the child sufficient to fund some or all of the costs of higher education.
If the business person were to set aside $3,772 annually, and if 4% gross income could be earned annually on those funds, the business could have an investment account worth $83,478 after 18 years, along with a balance in its refundable dividend tax account of $7,789. The accumulated savings should be able to support an annual dividend of $23,389 per year for 4 years. Since the accumulation was from income taxed at the low corporate tax rate, the dividend will be considered an ineligible dividend.
E.O. & E.
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Contributors to this edition:
James W. Kraft, cpa, ca, mtax, tep, cfp, clu, ch.f.c.
Deborah Kraft, mtax, tep, cfp, clu, ch.f.c.