Your little trust fund kid

What’s the best way to save for your child’s university education? A few weeks ago, I received a letter from a reader who was grappling with just that issue. She was already using a Registered Education Savings Plan (RESP), but she was interested in setting up an in-trust account too and wondered which was better.

The answer depends upon the specifics of your family situation. RESPs are simple and usually mean that you get free money, but there are some cases where the trust can be the better choice.

Why RESPs rock RESPs are a gift from the government, and for most people, they are the best way, hands down, to save for a child’s education. True, you don’t get a tax refund when you contribute to an RESP, but once the money is in your child’s RESP, it grows tax-free until Junior takes it out. To make the deal even better, most middle-class families are eligible for up to $500 in free government money each year that they contribute $2,500 or more to an RESP. Free money is not something you often come across, so grab it when you can.

Thanks to recent changes, RESPs are now more flexible than ever. The 2007 budget raised the lifetime contribution limit to $50,000, and eliminated the annual caps on contributions.

The best RESP strategy, if you have the time and the money, is to put the entire $50,000 into a regular investment account when your child is born. Then transfer $2,500 or more into your child’s RESP each year until all of the money is gone. That way you’ll get the maximum amount of compounding on your contributions, as well as the full $500 a year in free government money.

The trust advantage An in-trust account is a tool that allows you to give your children money for their future, while maintaining control over how the money is invested until the kids turn 18.

These accounts are a great notion if you’ve already invested $50,000 in an RESP and want to contribute even more to your kid’s education. You can use a trust, because they have no maximum.

In-trust accounts also shine if you want your child to get the money whether he or she goes to university or not. Unlike an RESP, these accounts don’t have to be used for education. That means your children could spend their trust money on anything they choose—which could be dangerous, but could also be more fair. Setting up a trust rather than an RESP could mean that you don’t end up giving thousands to an ungrateful son who goes to college and nothing to a daughter who decides to volunteer in Africa instead.

Of course, you could simply save up money for your kids in a regular account, but with trusts you don’t have to pay the taxes on capital gains. By depositing money in the account, you are essentially giving it to your kids (you’re just holding it “in trust”), so they pay the taxes on gains. Your kids will likely have little or no income when they turn 18 and start withdrawing the money, so they usually end up paying little or no tax, says Karen Yull, national tax principal at Grant Thornton LLP in Toronto.

Trusts are complicated so you should probably enlist the help of a lawyer and an accountant to set up yours. To make sure the taxman agrees that your account is really a trust, you should sign an agreement stating that deposits to the account are an irrevocable transfer of property to your child and that you agree to never take the money back or direct what happens to it. You should also make sure that the trustee and the person making the deposits are not the same person. Most families designate one spouse the trustee, and the other makes the deposits.

Finally, you should understand that even if you do all of that right, you generally still have to pay the taxes on dividends, interest or other income from the investments in the account. That means you should choose investments, such as stocks, that will experience most of their growth in the form of capital gains.

Taxes aren’t everything One final word of caution. Tax breaks are important, but never forget that deciding what kind of investment to purchase in the first place is more important.

The woman who wrote me the letter about trusts was worried about how to slash her taxes, but she had money that wasn’t going to be touched for 18 years sitting in a savings account that paid only 2.6%. Since inflation is now running at almost the same rate, there’s a good chance that her education fund will actually shrink over the long haul in real terms. If that happens, taxes are the least of your problems.