For those of us born before the 1980s, we enjoyed the benefits of affordable higher education and a fairly low entry point to the real estate market. For kids about to enter University, the tuition cost of a three year law program could easily run over $100,000, a two year MBA between $60,000 -100,000 and the 20% down payment for their first home in Toronto would likely be over $150,000. By comparison nearly 15 years ago, higher education was only about 10-15% of this cost and my first house down payment was less than $70,000 (and yes that was over 20% of the purchase price). Our children, while given nearly every advantage, may find it tougher making their way in the world and to move out of our basements unless we start planning now.
For parents (or grandparents) earning a combined income of over $250,000, below are three separate investment tools that can significantly enhance after-tax returns by 1) deferring taxes, and 2) transferring the tax burden to a lower income earner OR eliminating taxes altogether.
These strategies also provide additional funds for your children when they attend University and/or start their careers.
RESP – Registered Education Savings Plan
Most people are aware that the government provides a 20% grant (Canadian Education Savings Grant ‘CESG’) for every dollar contributed to a child’s RESP up to a maximum of $2,500 per year and a lifetime limit of $36,000 ($7,200 in grants), but many do not realize that the lifetime contribution limit is actually $50,000.
While the final $14,000 ($50,000 minus $36,000) does not receive grants, these funds enjoy two benefits: 1) tax-deferred compounding and 2) lower taxes on withdrawal.
If a parent were to contribute the additional $14,000 into an RESP shortly after her child was born and the funds were invested in balanced investment earning 6% per year, the funds can grow tax-deferred to approximately $40,000 before the child begins University. In fact, the investment could provide an additional $11,000 of spending per year for the son or daughter over a 4 year undergraduate degree.
Since these funds are withdrawn by your child, any tax attributable to the investment gets taxed in their hands. As your kid will be in school and likely earning little to no income, he or she will receive the full benefit of the tax deferred compound return on the investment, while paying little to no tax when withdrawing the funds.
Tax Free Savings Account
>Any Canadian citizen and resident 18 years of age or over, with a valid social insurance number (SIN) can open a TFSA and contribute the maximum annual amount of $5,500 per year. TFSA accounts enable investors to earn tax-free compounding and pay no tax when withdrawing funds.
If parents convince their teenager to open a TFSA account when she turns 18 and the parent provides her with $5,500 annually to invest in the account (there are no taxes on financial gifts), those funds could grow to over $75,000 before her 28th birthday, assuming an annual return of 6%. The $75,000 can be withdrawn without any penalty or tax AND the daughter will be able to contribute that $75,000 back to her TFSA when she has available funds for savings.
Overfunded Life Insurance policy
Life insurance can be a powerful estate planning tool for high income earners as investments compound tax free, providing additional tax shelter and withdrawals can be tax-free or as in the case described below, taxed at a much lower rate than that of the contributor. Death benefits are always tax-free.
We often suggest that high income earners take out / write an insurance policy on their young children. The benefits are many:
1) As the policy is started at a young age, the premium amount on your child is very low. While the child has no dependents to care for when the policy is started, it is a benefit to know that he has guaranteed life insurance in case he becomes ill or suffers a stroke or other ailment that would otherwise make him uninsurable later in life.
2) Many plans also offer critical illness insurance with the life policy, also at a very low rate due to the young age of the insured, so if he were to suffer a major illness later in life, your child would receive a tax free lump sum payout to help cover the lost income while receiving treatment.
3) The insurance plan can be a tax efficient savings vehicle.
There is typically a high limit for how much a policy can be overfunded (contributions greater than the premium amount). The additional funds can then be invested in a growth-oriented portfolio within a Universal Life policy.
The investments returns will compound on a tax-free basis as there is no taxation while the investment is growing within the policy. When your child turns 18, the ownership of the policy can be changed, i.e. instead of the parent being the owner of the policy, it can now be the child.
The main advantage is that after ownership has changed, no taxes can be attributed back to the original contributor (the parent). When your son decides to withdraw funds from the policy, the tax obligation will be on him, not the contributor.
Since your son will likely still be in school or not working when withdrawing the funds, the ultimate tax paid on the investment will be low and likely only a fraction of what would have been paid if the contributor (the parent) had invested the funds in a cash account.
Being tax smart with your investments can significantly enhance the cash available to your child for education and for purchasing a home. If you are already a good saver and are fully using the tax sheltering and deferral benefits of your TFSAs and RRSPs, the three options above are highly tax efficient ways to generate a much higher after-tax return and provide needed funds to your kids in some of their highest spending years.
To find out more about this and other tax effective investing and planning strategies, please contact Lorne Zeiler at 416-733-3292 x 225 or by e-mail at lorne@tridelta.ca.
Lorne Zeiler, MBA, CFA
VP, Wealth Advisor
Lorne can be reached by email at lorne@tridelta.ca or by phone at
416-733-3292 x225