One of the drawbacks of opening up an RESP account to save for your child’s post-secondary education is that if the child ends up not attending post-secondary education or quits early, then there are some penalties applied when the RESP account is collapsed.
How the penalties and taxes are applied if your RESP account is collapsed
When the account is collapsed then the following happens:
- Any RESP grants paid into the account are removed and sent back to the government.
- You can withdraw all your original RESP contributions without any taxation or penalties.
- Anything left in the account is taxed at your marginal tax rate plus 20%. This part of the withdrawal is called the Accumulated Income Payment (AIP).
How to avoid the RESP 20% penalty
All you have to do is contribute the accumulated income amount to your RRSP or your spouse’s RRSP. By doing this, you can avoid the 20% extra penalty and you will defer any income taxes that would have been due on the payment.
Here are the conditions necessary to be able to contribute the accumulated income amount from the RESP to an RRSP:
- Subscriber is a resident of Canada.
- Payment has to be make to only one subscriber of the plan.
- Plan has been open for at least 10 years and each individual who is or was a beneficiary, is over 21 years of age and not eligible for an educational assistance payment (EAP).
But I need the money!
No problem, contribute the AIP amount to the RRSP, wait until the following year and then withdraw the same amount from your RRSP. Assuming your marginal tax rate is unchanged between the time of the contribution and withdrawal then the amount of income tax paid will be the same as if you hadn’t contributed the AIP to the RRSP in the first place. And there is no 20% penalty!
What if my spouse and I don’t have any RRSP contribution room?
Good problem to have!. Assuming you are still working then you can just wait to collapse the RESP until the following year. Reduce your RRSP contributions appropriately so that you will have enough room next year to contribute the accumulated income portion of the RESP. In this case you are really only saving the 20% penalty since you are reducing your normal RRSP contribution by an amount equal to the AIP, but saving 20% is still very worthwhile.
Unfortunately, if you are too old to make rrsp contributions, then this plan won’t work.
My son just quit University after one year and there is still money in the RESP – do I have to pay a penalty to withdraw?
If you collapse the RESP account then the penalties and taxes will have to be paid. However, the 2008 budget allowed for EAP withdrawals up to 6 months after the child stops going to school. EAP withdrawals are when you withdraw the accumulated income from the RESP. These will be taxed in the hands of the student and won’t incur any penalties. If you are in that situation then just empty the account out as soon as possible. This strategy can only be used if the student starts post-secondary education.
From the RESP Promoter User Guide:
Six Month Grace Period
Budget 2008 introduced a six-month grace period for receiving an EAP to provide more flexibility for a beneficiary to access RESP savings. Under this measure, an RESP beneficiary is eligible to receive an EAP for up to six months after ceasing to be enrolled in a qualifying program, provided that the beneficiary would have qualified while still enrolled.
Check out my RESP rules guide for more information on RESP rules and how to set up an RESP account.