Last week's Investor Clinic item about withdrawing money from a registered education savings plan (RESP) prompted an interesting question from a reader.
It seems to me that the best approach is to leave the RESP funds untouched as long as possible to maximize tax-free compounding. My daughter is going to university in the fall, but – if I already have the cash to pay for her expenses – wouldn't I be better off leaving all of the money in the plan and only withdrawing it when I am required to?
Not necessarily. To understand why, we need to distinguish between different types of RESP withdrawals that you can make when your child is attending school. A refund of contributions (ROC) – as the name implies – is a withdrawal of money that was originally contributed to the plan. ROC withdrawals are not taxable.
An educational assistance payment (EAP), on the other hand, represents a withdrawal of income, capital gains and grants that have accumulated in the plan. EAPs are taxable in the hands of the beneficiary (i.e. the student). When you make an RESP withdrawal, you designate how much is ROC and how much is an EAP.
Because EAPs are taxable, it is usually advantageous to make these withdrawals when the student has minimal income. Depending on the size of the RESP, spreading EAPs over several years may also reduce the tax hit. Thanks to the basic personal tax credit and tuition tax credit, many students pay little or no tax on their EAPs.
Consider what could happen, however, if you were to wait several years and make one big EAP withdrawal just before your child graduates. The RESP would have benefited from additional years of tax-free growth, but your child could end up paying more tax because of the spike in her income that year. If she starts working right after graduation, her annual income – and taxes – would be even higher.
Here's another reason not to delay EAP withdrawals. If your child graduates or drops out of school and there is still grant money and income in the plan, the grants will ultimately have to be repaid and the withdrawal of the remaining income – called an Accumulated Income Payment (AIP) – will be taxable to the subscriber (usually the parent). What's more, the subscriber will be slapped with an additional 20-per-cent penalty tax, said Mike Holman, author of The RESP Book.
You can defer the income tax – and avoid the penalty – by rolling up to $50,000 of the AIP into an RRSP if sufficient contribution room is available. You can even make an EAP withdrawal for up to six months after the child has stopped going to school, so there's no reason to leave this money sitting in the plan, Mr. Holman said.
What about contributions? Should you leave them in the plan for as long as possible?
That may not a good idea, either, Mr. Holman said. An RESP can remain open for up to 35 years from the date it was started. But if you leave contributions in the plan for longer than the six-month grace period and your child doesn't go back to school, those contributions will generate income and gains that will ultimately have to be withdrawn from the plan as an AIP and taxed at punitive rates, he said.
"I can't think of how leaving contributions in the RESP would be advantageous unless the child plans to enroll in school again," Mr. Holman said. "I think it would always be worse than just withdrawing the contributions and putting them in a non-registered account or tax-free savings account."
What is the date acceptable by the Canada Revenue Agency for reporting the receipt of U.S. dividends?
For tax purposes, you're required to convert foreign income to Canadian dollars using the Bank of Canada exchange rate on the transaction date. You can also use that exchange rate to convert any U.S. tax withheld into Canadian dollars for the purposes of claiming a foreign tax credit.
If all that number-crunching sounds onerous, there's an easier way. According to the CRA, if there were "multiple payments at different times during the year" – for instance, if you received a stream of quarterly dividends from U.S. companies – it is acceptable to use the average annual exchange rate (which the Bank of Canada publishes on its website) to convert U.S. income to Canadian dollars.
Want to make things even simpler? Consider holding your U.S. stocks in a registered retirement savings plan or registered retirement income fund. In addition to paying no Canadian tax, you will avoid U.S. withholding tax, which is waived for retirement accounts under the Canada-U.S. tax treaty. But remember: If you hold U.S. stocks in a tax-free savings account or registered education savings plan, you will still face the 15-per-cent withholding tax on U.S. dividends. And you won't be able to claim a foreign tax credit for the amounts withheld.