Why do certain withdrawals from Registered Education Savings Plans incur penalties?
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On our platform, the curious user Camille Dauphinais-Pelletier asks: Why are taxable withdrawals by a young RESP beneficiary required, even though the money deposited by the plan's subscriber had already been taxed? Let's dive in.
To begin, it's crucial to recognize that the person contributing to a Registered Education Savings Plan (RESP) has, indeed, been taxed on their contributions. However, this only applies to a portion of the RESP account.
The account's contents can be divided into two amounts:
- The contributions made by the subscriber, which have already been taxed
- The rest of the money, including investment income and government grants, which is yet to be taxed
When a beneficiary starts their post-secondary education and withdrawals begin, the subscriber may select which part of the RESP they want to withdraw from.
If it's the subscriber's contributions, no tax is due, regardless of whether the money goes to the student or the subscriber recovers it.
Education Assistance Payments (EAPs)
However, when withdrawals come from the other segment of the account, known as EAPs, the amounts become taxable, and this is in the student's name.
"The student will receive a tax slip for this, as these amounts comprise grants and growth and have not been taxed as long as they remain in the account," explains financial advisor Benoit Gaudreau, associated with iA Private Wealth.
Theoretically, EAP money should be withdrawn when the student's income is at its lowest to minimize the tax paid on these amounts.
"Usually, this occurs during the student's time at CEGEP, when their income is at a minimum. That's when we want to withdraw the most EAPs. However, it's also when they need it the least," adds Gaudreau, whose firm Gaudreau Leclerc Investment Group specializes in managing RESPs.
Timing and Strategy
Postponing withdrawals, especially if the tax rules aren't well understood, can be tempting. However, it's advisable to make the EAP withdrawal first. This is because, in most cases, the student begins their studies in the fall, and there's a clear picture of their student employment income for the year.
For the 2025 tax year, the federal threshold stands at $16,129, and the provincial threshold is $18,571.
If the student doesn't require the withdrawn funds for the year and has turned 18, it may be smart to open a Tax-Free Savings Account (TFSA) for them and deposit the money during their studies. This allows the money to grow tax-free.
If the subscriber is concerned about the student misusing the money, they can request that the financial institution deposit the money into their own account – even though it will be taxed in the student's name – and then manage the distribution to the student at their discretion.
Choice of Studies
The withdrawal strategy can be influenced by the student's chosen field of study. If the student plans to enroll in a university program that includes paid internships, their income during university will likely be higher, possibly leading to paying tax on the EAPs. In this scenario, a more immediate withdrawal of the Canada Education Savings Grant (CESG) becomes even more relevant.
On the flip side, if the student's studies are expected to be short, it's crucial not to delay the withdrawal of the CESG. It's preferable to pay tax on these amounts rather than leaving them in the account, as they would otherwise be returned to the government. If the income related to growth isn't withdrawn, the holder can potentially transfer it to their Registered Retirement Savings Plan (RRSP), if there are still contribution opportunities. Otherwise, the untaxed investment earnings will be taxed at a higher rate.
In essence, the untaxed amounts in an RESP must be withdrawn at a time when the student is projected to have the least income. Keep in mind that while contributions to an RRSP are tax-deductible in the year made, withdrawals are taxed as income because they represent previously untaxed income. The taxation of RESPs and RRSPs serves distinct policy objectives: RESPs aim to promote education funding by shifting the tax burden to a later stage, while RRSPs aim to foster retirement savings by deferring taxation until withdrawal.
Firstly, when a beneficiary withdraws Education Assistance Payments (EAPs) from a Registered Education Savings Plan (RESP), these amounts become taxable and are listed in the student's name. Secondly, to minimize the tax paid on EAPs, it's theoretically strategic to withdraw these funds during the student's time at CEGEP or when their income is at a minimum.