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I have a family registered education savings plan for my three kids, the oldest of whom is starting university this fall. I’ve contributed $88,000 to the RESP and received $17,600 in Canada Education Savings Grants (CESGs), for a total of $105,600. However, some investments I made didn’t work out and the RESP is now worth about $80,600, for a net loss of $25,000. Is tax still payable on the full amount of the grants when the money is withdrawn?

First, my sympathies. I remember how difficult it was to watch my kids’ RESP plunge in value during the 2008 financial crisis. RESPs are designed to help our children get off to a good start in life, so losses have an emotional dimension. What’s more, parents typically tap RESPs long before they start withdrawals from a registered retirement savings plan, so there’s less time for an RESP to recover from losses. That’s why it’s important to choose conservative investments for an RESP and dial back the risk level as the beneficiaries approach postsecondary school age.

Fortunately, my kids’ RESP has bounced back over the past decade, but what are the consequences for parents who have to tap an RESP when it’s still in a loss position? As you’ll see, the government still wants its pound of flesh.

Let’s quickly review how RESP withdrawals work.

When the subscriber (typically a parent or grandparent) makes an RESP withdrawal, he or she designates what portion is a return of the original contributions (which are not taxable) and what portion consists of grants and investment earnings that have accumulated inside the plan. On their withdrawal, grants and earnings are called educational assistance payments (EAPs) and are taxed in the hands of the student. EAP withdrawals are limited to $5,000 during the first 13 consecutive weeks of enrolment, after which there are no restrictions unless the student takes a break from school and doesn’t re-enroll for 12 months.

When an EAP is requested, the government uses a formula to determine how much of the EAP consists of grants and how much consists of investment earnings. To take a simple example, if the RESP has total CESGs of $3,000 and total earnings of $7,000, an EAP withdrawal of $5,000 would be deemed to consist of $1,500 of CESGs and $3,500 of earnings, matching the 30-70 split of CESGs and earnings in the RESP. The RESP’s remaining “notional” balance of CESGs and earnings would be reduced accordingly. (The calculation is more complicated if the RESP also has provincial grants and the Canada Learning Bond.)

But what happens if, as in the reader’s case, there are no investment earnings in the RESP? In such situations, an EAP would consist entirely of grants.

“Bottom line is that for an account with no accumulated income (i.e. no gains) the grant money still lives on for the purpose of EAP withdrawals, regardless of the account balance,” Mike Holman, author of The RESP Book, said in an e-mail.

In other words, the RESP’s $25,000 loss would be considered to have come entirely out of the reader’s own contributions; the loss would not reduce the $17,600 of CESGs, which will become taxable when withdrawn as EAPs. “If he does a $5,000 EAP this fall, it will be all from the grant amount in the account,” Mr. Holman said.

The good news is that, because many postsecondary students have little or no additional income, EAPs often attract little, if any, tax. But if the student has other income from, say, a part-time job, he or she could end up paying tax on EAPs.

Now, what if someone got really, really unlucky and the RESP’s value fell to less than the total amount of the grants received in the plan? “In that situation, the maximum EAP amount available is the fair market value of the plan,” the government explains in its RESP user guide for financial institutions. In other words, an EAP can never exceed the RESP’s value.

There are a couple of lessons here. The first is that RESPs are no place for risky investments. The second is that, even if you lose money in an RESP, the full amount of the grants is still taxable when you start making withdrawals.

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