This is the second in a four-part series looking at the ins and outs of the new tax-free savings account.
The tax-free savings account, or TFSA, will be an enormously versatile savings, investment and cash-flow management tool when it becomes available at the beginning of January. Besides supplementing tax-sheltered money in RRSPs and RRIFs, the TFSA can pick up where registered education savings plans (RESPs) leave off.
Currently, many parents cease contributing to a child's RESP after age 17, the last year RESPs generate the 20% Canada Education Savings Grant (CESG). Coincidentally, the age at which teens can open their own TFSA is 18.
RESP contributions can still be made after the grant is no longer available, notes Debbie Ammeter, director of Advanced Financial Planning for Winnipeg-based Investors Group. "There are some intriguing things that can be done with the RESP and TFSA," she says, particularly if there is not enough money to maximize both.
For example, if you only have $5,000 to save per child, you might put the first $2,500 into an RESP to maximize the grant and put the other $2,500 in the TFSA, maximizing flexibility. "With the TFSA, you can do what you want, so it's comforting to know it's there. You may well intend to use it for the child's education, but if something else comes up you don't have to."
Parents must balance the plus of the RESP grant against the reduced flexibility of the RESP, says Sandy Cardy, vice-president, tax and estate planning, for Mackenzie Financial Corp. "If you discount the grant, I'd say the TFSA is superior."
If an RESP is only large enough to fund four years of university, additional contributions to a student's TFSA could fund post-graduate work. RESPs require investments be dedicated to post-secondary education. If the student opted to curtail higher education after only a year or two as an undergraduate, money saved in a more flexible TFSA would be available with no strings attached, whether used for an extended vacation, to start a business or splurge on a car.
Before TFSAs, it often made sense to continue to contribute to RESPs past 18, just for its ability to shelter interest income from tax. By age 18, RESPs should no longer be in equities because you don't want to encounter stock market risk within five years of needing the money.
TFSAs may also replace another education savings option for parents --in-trust-for (ITF) mutual accounts. Equity mutual funds held in trust for children are usually tax-free since any capital gains accrue in the child's name. But ITF accounts attribute any interest income back to the parent. Since education savings plans should be mostly in interest-bearing investments once post-secondary education looms, ITF accounts have become less appealing. True, ITF accounts don't have to be dedicated to education, and in that respect they are more flexible than RESPs. But TFSAs are more flexible than both RESPs and ITF accounts.
TFSAs can also be used by adults who plan to go back to school. Currently, under the RRSP Lifelong Learning Plan, RRSP holders can withdraw up to $20,000 spread over four years (no more than $10,000 withdrawn in any one year). But the rules force them to repay the RRSP. Meantime, the RRSP loses the growth intended to boost retirement.
"I think if I had the choice of saving for my education, I'd do that in a TFSA and leave the RRSP for retirement savings," Ammeter concludes.
Jamie Golombek, managing director of tax and estate planning for CIBC, offers another TFSA tactic that could help with education costs. While RESP income, growth and grants are technically taxable in a child's name, most students will pay minimal tax because of the basic $9,500 personal exemption, plus tuition, textbook and other credits. So, for most students, the first $18,000 of income should generate little or no tax. If the student needs more than that amount (high costs of a prestigious university abroad, for example), and his or her RESP has been maxed out and the parents have maxed out their own TFSAs, they could gift the child's TFSA once they are 18, Golombek suggests.
Parents should first max out the CESG to the $7,200 per child limit, Cardy says. That's assuming the child will hang in for three or four years in post-secondary school. Under the less common scenario of a student having to pay high amounts of tax after receiving an inheritance or other income on top of an RESP, the TFSA is a superior way to go, she says.
Gordon Pape devotes a chapter to comparing RESPs and the TFSA in his soon-to-be-published book Tax-Free Savings Accounts (Penguin Canada, 2009). He concludes that in most cases, it is better to go with the RESP because of the grant, which is basically free money from government.
Jonathan Chevreau blogs at financialpost.com/wealthyboomer
